Intermediate Financial Accounting II

CHAPTER FOUR
LEASES

4.1 THE LEASING ENVIRONMENT

Aristotle once said, “Wealth does not lie in ownership but in the use of things!” Clearly, many
companies have decided that Aristotle is right, as they have become heavily involved in leasing assets
rather than owning them.

A lease is a contractual agreement between a lessor and a lessee that gives the lessee, for a specified
period of time, the right to use specific property owned by the lessor in return for specified, and
generally periodic, cash payments (rents). An essential element of the lease agreement is that the
lessor transfers less than the total interest in the property. Because of the financial, operating, and risk
advantages that the lease arrangement provides, many businesses and other types of organizations
lease substantial amounts of property as an alternative to ownership. Any type of equipment or
property can be leased, such as railcars, helicopters, bulldozers, schools, golf club facilities, barges,
medical scanners, computers, and so on. The largest class of leased equipment is information
technology equipment. Next are assets in the transportation area, such as trucks, aircraft, and railcars.

Who Are the Players?

A lease is a contractual agreement between a lessor and a lessee. This arrangement gives the lessee
the right to use specific property, owned by the lessor, for an agreed period of time. In return for the
use of the property, the lessee makes rental payments over the lease term to the lessor.
☞ Who are the lessors that own this property? They generally fall into one of three categories:
I. Banks - Banks are the largest players in the leasing business. They have low-cost funds, which
give them the advantage of being able to purchase assets at less cost than their competitors.
Banks also have been more aggressive in the leasing markets. They have decided that there is
money to be made in leasing, and as a result they have expanded their product lines in this area.
Finally, leasing transactions are now more standardized, which gives banks an advantage
because they do not have to be as innovative in structuring lease arrangements.
II. Captive leasing companies - Captive leasing companies are subsidiaries whose primary
business is to perform leasing operations for the parent company.

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III. Independents - Independents are the final category of lessors. Independents have not done well
over the last few years. Their market share has dropped fairly dramatically as banks and captive
leasing companies have become more aggressive in the lease-financing area. Independents do
not have point-of-sale access, nor do they have a low cost of funds advantage. What they are
often good at is developing innovative contracts for lessees. In addition, they are starting to act as
captive finance companies for some companies that do not have a leasing subsidiary.
Advantages of Leasing
The growth in leasing indicates that it often has some genuine advantages over owning property, such
as:
1. 100% financing at fixed rates - Leases are often signed without requiring any money down
from the lessee. This helps the lessee conserve scarce cash—an especially desirable feature for
new and developing companies. In addition, lease payments often remain fixed which protects
the lessee against inflation and increases in the cost of money. The following comment
explains why companies choose a lease instead of a conventional loan: “Our local bank finally
came up to 80 percent of the purchase price but wouldn’t go any higher, and they wanted a
floating interest rate. We just couldn’t afford the down payment, and we needed to lock in a
final payment rate we knew we could live with.”
2. Protection against obsolescence- Leasing equipment reduces risk of obsolescence to the
lessee, and in many cases passes the risk of residual value to the lessor. For example, Elan
(IRL) (a pharmaceutical maker) leases computers. Under the lease agreement, Elan may turn
in an old computer for a new model at any time, canceling the old lease and writing a new
one. The lessor adds the cost of the new lease to the balance due on the old lease, less the old
computer’s trade-in value. As one treasurer remarked, “Our instinct is to purchase.” But if a
new computer is likely to come along in a short time, “then leasing is just a heck of a lot more
convenient than purchasing.” Naturally, the lessor also protects itself by requiring the lessee to
pay higher rental payments or provide additional payments if the lessee does not maintain the
asset.
3. Flexibility- Lease agreements may contain less restrictive provisions than other debt
agreements. Innovative lessors can tailor a lease agreement to the lessee’s special needs. For
instance, the duration of the lease—the lease term—may be anything from a short period of
time to the entire expected economic life of the asset. The rental payments may be level from

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year to year, or they may increase or decrease in amount. The payment amount may be
predetermined or may vary with sales, the prime interest rate, a price index, or some other
factor. In most cases, the rent is set to enable the lessor to recover the cost of the asset plus a
fair return over the life of the lease.
4. Less costly financing- Some companies find leasing cheaper than other forms of financing.
For example, start-up companies in depressed industries or companies in low tax brackets
may lease to claim tax benefits that they might otherwise lose. Depreciation deductions offer
no benefit to companies that have little if any taxable income. Through leasing, the leasing
companies or financial institutions use these tax benefits. They can then pass some of these
tax benefits back to the user of the asset in the form of lower rental payments.
5. Tax advantages - In some cases, companies can “have their cake and eat it too” with tax
advantages that leases offer. That is, for financial reporting purposes, companies do not report
an asset or a liability for the lease arrangement. For tax purposes, however, companies can
capitalize and depreciate the leased asset. As a result, a company takes deductions earlier
rather than later and also reduces its taxes. A common vehicle for this type of transaction is a
“synthetic lease” arrangement, such as that described in the opening story for Krispy Kreme
(USA).
6. Off-balance-sheet financing- Certain leases do not add debt on a statement of financial
position or affect financial ratios. In fact, they may add to borrowing capacity. Such off
balance-sheet financing is critical to some companies.

ACCOUNTING BYTHE LESSEE

If Air France (the lessee) capitalizes a lease, it records an asset and a liability generally equal to the
present value of the rental payments. ILFC (the lessor), having transferred substantially all the
benefits and risks of ownership, recognizes a sale by removing the asset from the statement of
financial position and replacing it with a receivable.

A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental
to ownership. In order to record a lease as a finance lease, the lease must be non-cancelable. The
IASB identifies the four criteria listed for assessing whether the risks and rewards have been
transferred in the lease arrangement.

Capitalization Criteria

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Three of the four capitalization criteria that apply to lessees are controversial and can be difficult
to apply in practice. We discuss each of the criteria in detail on the following:
♦ Transfer of Ownership Test - If the lease transfers ownership of the asset to the lessee, it is a
finance lease. This criterion is not controversial and easily implemented in practice.
♦ Bargain-Purchase Option Test - A bargain-purchase option allows the lessee to purchase the
leased property for a price that is significantly lower than the property’s expected fair value
at the date the option becomes exercisable. At the inception of the lease, the difference
between the option price and the expected fair value must be large enough to make exercise of
the option reasonably assured.
♦ Economic Life Test - If the lease period is for a major part of the asset’s economic life, the
lessor transfers most of the risks and rewards of ownership to the lessee. Capitalization is
therefore appropriate. However, determining the lease term and what constitutes the major
part of the economic life of the asset can be troublesome.
The IASB has not defined what is meant by the “major part” of an asset’s economic life. In
practice, following the IASB hierarchy, it has been customary to look to U.S. GAAP, which
has a 75 percent of economic life threshold for evaluating the economic life test. While the 75
percent guideline may be a useful reference point, it does not represent an automatic cutoff
point.
♦ Recovery of Investment Test - If the present value of the minimum lease payments equals or
exceeds substantially all of the fair value of the asset, then a lessee should capitalize the leased
asset.

As with the economic life test, the IASB has not defined what is meant by “substantially all” of an
asset’s fair value. In practice, it has been customary to look to U.S. GAAP, which has a 90 percent of
fair value threshold for assessing the recovery of investment test. Again, rather than focusing on any
single element of the lease classification indicators, lessees and lessors should consider all relevant
factors when evaluating lease classification criteria

Determining the present value of the minimum lease payments involves three important concepts:
1. Minimum Lease Payments- The lessee is obligated to make, or expected to make, minimum
lease payments in connection with the leased property. These payments include: Minimum

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rental payments, Guaranteed residual value, Penalty for failure to renew or extend the lease
and Bargain-purchase option
2. Executory Costs - Like most assets, leased tangible assets incur insurance, maintenance, and
tax expenses—called executory costs—during their economic life. Executory costs do not
represent payment on or reduction of the obligation. Many lease agreements specify that the
lessee directly pays executory costs to the appropriate third parties. In these cases, the lessor
can use the rental payment without adjustment in the present value computation
3. Discount Rate- A lessee computes the present value of the minimum lease payments using
the implicit interest rate. This rate is defined as the discount rate that, at the inception of the
lease, causes the aggregate present value of the minimum lease payments and the
unguaranteed residual value to be equal to the fair value of the leased asset.

Asset and Liability Accounted for Differently

In a finance lease transaction, the lessee uses the lease as a source of financing. The lessor
finances the transaction (provides the investment capital) through the leased asset. The lessee makes
rent payments, which actually are installment payments. Therefore, over the life of the rented
property, the rental payments to lessor constitute a payment of principal plus interest.

Asset and Liability Recorded

Under the finance lease method, the lessee treats the lease transaction as if it purchases the leased
property in a financing transaction. That is, lessee acquires the property and creates an obligation.
Therefore, it records a finance lease as an asset and a liability at the lower of:
(1) The present value of the minimum lease payments (excluding executor costs) or
(2) The fair value of the leased asset at the inception of the lease.

The rationale for this approach is that companies should not record a leased asset for more than its
fair value.

Depreciation Period
One troublesome aspect of accounting for the depreciation of the capitalized leased asset relates to the
period of depreciation. If the lease agreement transfers ownership of the asset to lessee (criterion 1) or
contains a bargain-purchase option (criterion 2), lessee depreciates the leased property consistent with
its normal depreciation policy for other leased property, using the economic life of the asset

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On the other hand, if the lease does not transfer ownership or does not contain a bargain-purchase
option, then lessee depreciates it over the term of the lease. In this case, the leased property reverts to
lessor after a certain period of time.

Effective-Interest Method
Throughout the term of the lease, the lessee uses the effective-interest method to allocate each lease
payment between principal and interest. This method produces a periodic interest expense equal to a
constant percentage of the carrying value of the lease obligation. When applying the effective-interest
method to finance leases, lessee must use the same discount rate that determines the present value of
the minimum lease payments.

Depreciation Concept
Although lessee computes the amounts initially capitalized as an asset and recorded as an obligation
at the same present value, the depreciation of the leased property and the discharge of the
obligation are independent accounting processes during the term of the lease. It should depreciate
the leased asset by applying conventional depreciation methods: straight-line, sum-of-the-years’
digits, declining-balance, units of production, etc.

Finance Lease Method (Lessee)

To illustrate a finance lease, assume that CNH Capital (NLD) (a subsidiary of CNH Global) and
Ivanhoe Mines Ltd. (CAN) sign a lease agreement dated January 1, 2015, that calls for CNH to lease
a front-end loader to Ivanhoe beginning January 1, 2015. The terms and provisions of the lease
agreement and other pertinent data are as follows.
 The term of the lease is five years. The lease agreement is non-cancelable, requiring equal
rental payments of $25,981.62 at the beginning of each year (annuity-due basis).
 The loader has a fair value at the inception of the lease of $100,000, an estimated economic
life of five years, and no residual value.
 Ivanhoe pays all of the executory costs directly to third parties except for the property taxes of
$2,000 per year, which is included as part of its annual payments to CNH.
 The lease contains no renewal options. The loader reverts to CNH at the termination of the
lease.
 Ivanhoe’s incremental borrowing rate is 11 percent per year.
 Ivanhoe depreciates similar equipment that it owns on a straight-line basis.

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 CNH sets the annual rental to earn a rate of return on its investment of 10 percent per year;
Ivanhoe knows this fact

The lease meets the criteria for classification as a finance lease for the following reasons.
1. The lease term of five years, being equal to the equipment’s estimated economic life of five
years, satisfies the economic life test.
2. The present value of the minimum lease payments ($100,000) equals the fair value of the
loader ($100,000)

The minimum lease payments are $119,908.10 ($23,981.62 * 5). Ivanhoe computes the amount
capitalized as leased assets as the present value of the minimum lease payments (excluding executory
costs—property taxes of $2,000).

Operating Method (Lessee)

Under the operating method, rent expense (and the associated liability) accrues day by day to the
lessee as it uses the property. The lessee assigns rent to the periods benefiting from the use of the
asset and ignores, in the accounting, any commitments to make future payments. The lessee makes
appropriate accruals or deferrals if the accounting period ends between cash payment dates.

Comparison of Finance Lease with Operating Lease

The total charges to operations are the same over the lease term whether accounting for the lease as a
finance lease or as an operating lease. Under the finance lease treatment, the charges are higher in the
earlier years and lower in the later years. If using an accelerated method of depreciation, the
differences between the amounts charged to operations under the two methods would be even larger
in the earlier and later years. If using a finance lease instead of an operating lease, the following
occurs:
(1) An increase in the amount of reported debt (both short-term and long-term),
(2) An increase in the amount of total assets (specifically long-lived assets), and
(3) Lower income early in the life of the lease and, therefore, lower retained earnings.

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