978-0078025679 Chapter 12 Lecture Note

Financial Reporting and Analysis 6e Financial Reporting for Leases

CHAPTER 12

FINANCIAL REPORTING FOR LEASES

Chapter Overview

The treatment of leases in FASB ASC 840 represents a compromise between the

unperformed–contract and property-right approaches. FASB ASC 840 adopts a middle-of–the-

road position that neither capitalizes all leases nor prohibits capitalization. Instead, the FASB

developed criteria for determining the precise intermediate circumstances under which leases

would be capitalized.

The lease capitalization criteria rely on bright-line rules such as 75% of economic life and

90% of fair value. Because lease capitalization adversely affects lessees’ financial statements,

many lessees structure agreements to avoid lease capitalization.

The proportion of operating lease commitments to capital lease commitments can vary

greatly even between firms in the same industry. This complicates financial analysis because

keeping leases off the balance sheet improves various ratios (e.g., turnover, debt-to-equity, and

the current ratio). Consequently, analysts must constructively capitalize operating leases to make

valid comparisons between firms with different proportions of capitalized leases.

Lessors’ use of the capital lease approach accelerates income recognition in contrast to the

timing of income recognition under the operating lease approach. Lessors’ financial statements

ratios are also improved. It is perhaps not surprising, therefore, that capital leases appear

frequently on lessors’ financial statements.

The FASB and IASB have issued a jointly developed exposure draft on lease accounting.

The proposed accounting adopts a “right–of–use” approach and would require lessees to treat

most leases as capital leases. However, the exposure draft introduces a controversial second

method of accounting for real estate leases that is essentially capital lease accounting on the

balance sheet and operating lease accounting on the income statement and statement of cash

flows. Lessors would have a different model of accounting for real estate leases.

CHAPTER OUTLINE

I. EVOLUTION OF LEASE ACCOUNTING

A. A lease is a contract in which the owner of an asset (the lessor) conveys to another party

(the lessee) the right to use that asset.

1. This right is granted in exchange for a fee (the lease payment) that is usually paid

in installments.

2. Legal title to the asset typically remains with the lessor.

3. At its inception, a lease is what is usually called a mutually unperformed

contract (also called an executory contract), meaning that neither party to the

lease arrangement has yet performed all of the duties called for in the contract.

B. Currently contained under the FASB Accounting Standards Codification Topic 840,

the pre-codification SFAS No. 13 spells out the GAAP for leases.

1. Prior to the issuance of pre-codification SFAS No. 13, virtually all leases were

accounted for using the operating lease approach.

a. The accounting for operating leases conforms to the legal structure of

lease arrangements.

b. Since lease contracts typically do not convey title, the asset remains on the

books of the lessor.

Financial Reporting and Analysis 6e Financial Reporting for Leases

c. The lessee does not immediately record as a liability the stream of future

payments called for in the contract because the lessee is not legally obligated

to make the payments until the lessor performs the duties specified in the

contract.

d. Upon payment of the stipulated rental, the lessee debits rent expense

and credits cash.

e. The lessor records rent revenue as performance takes place.

2. Why Lessees Like the Operating Lease Method: The term off-balance sheet

financing means the lessee has financed the acquisition of asset services without

recognizing a liability on the financial statements.

a. GAAP requires footnote disclosure of the lessee’s future cash flows arising

from operating leases.

b. The appendix to this chapter explains how to make adjustments for off-

balance sheet leases.

3. Keeping the lease liability off the books conveys benefits to borrowers even if the

liabilities are not hidden in a real sense. These benefits are just as substantial as

the benefit from omitting lease liabilities.

4. Keeping the leased asset off the books produces a favorable impact on the

lessee’s financial statements that is as substantial as that from omitting the lease

liabilities.

5. The off-balance sheet liability reduces the likelihood that the lessee-borrower will

violate debt-to-equity loan covenants.

6. Operating leases make the leverage and turnover ratios appear to be more favorable

than the corresponding ratios for companies that own their assets.

C. The Securities and Exchange Commission’s Initiative: More recently, the SEC

issued Accounting Series Release (ASR) No. 147 to improve financial reporting for

leases. It took a property rights approach to the lease accounting. The property rights

approach views leases as conveying property rights in the asset to the lessee and the

payment stream as representing the lessee’s liability. Both asset and liability are

recorded. This is called the capital lease approach. ASR 147 emphasizes disclosure but

does not require balance sheet recognition.

II. LESEE ACCOUNTING

A. Under the FASB Accounting Standards Codification Topic 840, Lessees must

capitalize leases that meet certain specified criteria that is defined as essentially

transferring substantially all of the benefits and risks of ownership.

B. Leases that do not meet the FASB’s ASC 840 criteria cannot be capitalized, and are

accounted for as operating leases as described in the previous section.

C. If at its inception a lease satisfies any one or more of the following criteria, it must be

treated as a capital lease on the books of the lessee:

1. The lease transfers ownership of the asset to the lessee by the end of the lease term.

2. The lease contains a bargain purchase option.

3. The noncancelable lease term is 75% or more of the estimated economic life of the

leased asset.

4. The present value of minimum lease payments equals or exceeds 90% of the fair

value of the leased asset. (This is also referred to as the recovery of investment

criterion.)

D. Each criterion represents a condition under which property rights in the leased asset

have been transferred to the lessee. Current authoritative accounting literature presents

Financial Reporting and Analysis 6e Financial Reporting for Leases

a compromise between the operating lease approach and a strict property rights

approach.

E. Capital lease accounting:

1. The lessee must recognize both an asset and a liability on its books as the dollar

amount equal to the discounted present value of the minimum lease payments

specified in the lease.

a. Contingent rentals are ignored.

b. The discount rate that is used to determine the present value is the lower of

the lessee’s incremental borrowing rate or the lessor’s rate of return that is

implicit to the lease.

c. The amount recorded for both the asset and the liability is equal only at the

inception of the lease.

2. Each lease payment includes both interest (measured using the effective interest

method) and principal reduction.

3. Depreciation expense in accordance with the lessee’s depreciation schedule for

assets of this type is also recorded.

4. Executory costs (costs of using assets), including maintenance, insurance, taxes,

and other incidental costs of using the leased asset, are omitted when determining

minimum lease payments.

a. Executory costs are not included in either the capitalized asset or the liability.

b. Executory costs are treated as period costs that are charged to expense when

paid.

5. A residual value guarantee requires a lessee to pay a lessor the difference if the

actual market value of the leased asset falls below the guaranteed residual amount.

a. The lessee must include the amount specified as the residual value guarantee

in the computation of the minimum lease payment since the lessee potentially

owes the full amount of the guarantee to the lessor.

b. If the guaranteed residual at the end of the lease exceeds the market value of

the leased asset, then the lessee records a loss equivalent to the cash paid to

the lessor.

c. If the guarantee requires no payment, then the remaining asset and liability

balances are eliminated, with no resulting profit effect.

d. The residual value guarantee gives lessor protection against lessees who

abuse leased assets.

6. Payments in Advance: When lease payments are due at the start of each lease

period, the entries differ from those with payment starting later.

F. Financial Statement Effects of Treating a Lease as a Capital Lease versus

Treating it as an Operating Lease:

1. The two methods give rise to identical cumulative total lifetime charges to

expense.

a. Under the operating lease method, the total rent expense over the life of the

lease is equal to the total lease payments.

b. Under the capital lease method, the total lease expense over the life of

the lease comprises both:

i. The interest payments, and

ii. The amortization of the capitalized asset amount.

2. However, the timing of the expense charges differs between the two methods.

a. The capital lease approach leads to higher expense in the earlier years of the

lease and lower expense in the later years.

b. The operating lease approach leads to a constant lease expense each year

Financial Reporting and Analysis 6e Financial Reporting for Leases

even if the payments do not follow this pattern.

c. This accelerated recognition of lease expenses under the capital lease

approach provides another reason why many lessees prefer the

operating lease method.

Teaching Tip: Capital leases result in higher operating income (earnings before interest

and taxes) since annual straight-line depreciation expense is lower than the annual rental

expense reported under the operating lease method. For an individual lease, this difference

is never reversed and remains constant over the lease term, given constant lease payments

and use of the straight-line depreciation method.

G. The current ratio over the lease term will be lower under the capital lease approach than

it would be under the operating lease approach.

H. Cash flow statement implications also arise from lease treatment.

1. For capital leases, only the interest portion of each lease payment is reported as

an operating cash outflow, while the principal reduction portion of each lease

payment is reported as a financing cash outflow.

2. For operating leases, each lease payment is reported as an operating cash outflow.

I. Lessee’s Financial Statement Disclosures: A schedule of future minimum lease

payments (may be aggregated) must be reported both for capital leases and

operating leases. U.S. GAAP requires the disclosure of present value of minimum

lease payments only for capital leases.

III. LESSOR ACCOUNTING

A. Treating a lease as a capital lease on the lessor’s books accelerates the timing of the

recognition of leasing income. From the perspective of the lessor, the lease is treated as

a capital lease if a lease arrangement (1) transfers property rights in the leased asset to the

lessee and (2) allows reasonably accurate estimates regarding the amount and

collectibility of the eventual net cash flows to the lessor.

1. If both conditions for capital lease treatment are not simultaneously met, the lease

must be treated as an operating lease.

2. In a capital lease, the leased asset is removed from the lessor’s books.

3. There are two types of capital leases for lessors:

a. A sales-type lease exists when the lessor is a manufacturer or dealer.

b. A direct financing lease exists when the lessor is a financial institution.

B. Sales-type leases can serve as a marketing tool since leasing arrangements generate

“sales” from potential customers who are unwilling or unable to buy the assets outright

for cash.

1. The lessor earns a profit from two sources:

a. A manufacturer’s or dealer’s profit which is the difference between

the cash selling price (fair value) and its cost to the manufacturer or

dealer.

b. A financing profit which is the difference between the total (undiscounted)

minimum lease payments plus unguaranteed residual value and the fair value

of the leased asset.

2. At inception of the lease:

a. The lessor records an asset called “Gross investment in leased asset”—the sum

of the minimum lease payments plus the guaranteed residual value of the asset

at the end of the lease term. (Think of this asset account as an account

receivable.)

Financial Reporting and Analysis 6e Financial Reporting for Leases

b. The lessor credits sales revenue for the cash selling price of the leased asset.

c. The lessor credits “Unearned financing income” for the excess of the gross

investment in leased assets over its fair market value.

d. Cost of goods sold and the reduction in inventory are also recorded.

3. Financing profit is recognized over the life of the lease.

a. The total cash receipt is credited to the “Gross investment in leased assets”

account.

b. Annual financing profit is calculated using the effective interest method

and is debited to the “Unearned financing income” account.

C. Direct financing leases exist when a third-party financial institution provides lessees

with the means for financing asset acquisitions.

1. These organizations acquire assets from manufacturers by paying the fair market

value and then leasing the asset to the lessee.

2. These lessors earn their profit from a single source—the finance fee that they charge

the lessee for financing the asset acquisition.

3. At inception of the lease:

a. The lessor records an asset called “Gross investment in leased asset”—the sum

of the minimum lease payments plus the guaranteed residual value of the asset

at the end of the lease term. (Think of this asset account as an account

receivable.)

b. The lessor credits the equipment account for the fair market value of the leased

asset.

c. The lessor credits “Unearned financing income” for the excess of the

gross investment in leased assets over its fair market value.

4. Financing profit is recognized over the life of the lease.

a. The total cash receipt is credited to the “Gross investment in leased assets”

account.

b. Annual financing profit is calculated using the effective interest method

and is debited to the “Unearned financing income” account.

Teaching Tip: Most lessors net the “Unearned financing income” account against the

“Gross investment in leased asset” account. Under both the sales-type and direct financing

leases, this net amount equals the fair value of the equipment leased. This parallels, in

many ways, the accounting for sales under the installment sales method, discussed in detail

in Chapter 3, where the deferred gross profit is often deducted on the balance sheet from

gross installment accounts receivable. Note that this accounting “understates” the net

realizable value of these “net receivables” relative to the actual gross collections that are

expected.

D. Lessor’s operating leases result when the leased asset is not considered “sold.”

1. The leased asset remains on the books of the lessor.

2. Rental revenue is recognized when each lease payment is earned.

3. Depreciation expense in accordance with the lessor’s depreciation schedule for

assets of this type is also recorded each period.

E. Distinction between Capital and Operating Leases: A lease meeting at

least one of the Type I characteristics and both of the Type II characteristics

is classified as a capital lease.

1. Type I characteristics are identical to the lessee’s criteria for capital lease

Financial Reporting and Analysis 6e Financial Reporting for Leases

treatment.

a. The lease transfers ownership of the asset to the lessee by the end of the

lease term.

b. The lease contains a bargain purchase option.

c. The noncancelable lease term is 75% or more of the estimated economic life

of the leased asset.

d. The present value of minimum lease payments equals or exceeds 90% of the

fair value of the leased asset.

2. Type II characteristics establish the appropriate time for recognizing income

on the lessor’s books.

a. The collectibility of the minimum lease payments is reasonably predictable.

b. No important uncertainties surround the amount of unreimbursable costs yet

to be incurred by the lessor under the lease.

3. When at least one of the Type I characteristics and both of the Type II

characteristics are satisfied by a lease, the criteria for revenue recognition are

met and the sale, matched costs, and the profit can be recognized

immediately.

4. FASB ASC 840 tries to establish symmetry in the accounting for leases by

lessors and lessees, but this symmetry is not perfect.

F. Guaranteed versus Unguaranteed Residual Values:

1. Lease contracts do not usually require lessee to guarantee that the residual value

will exceed a certain amount.

2. Only guaranteed residual values are obligations to the lessee and are included in

the minimum lease payments.

G. Financial Statement Effects of Direct Financing versus Operating Leases:

1. Income over the life of the lease is unaffected by the accounting method used.

2. However, the timing of income does differ between the two methods.

a. The direct financing method recognizes income sooner.

b. This income timing difference widens if an accelerated depreciation

method, as opposed to the straight-line method, is used in conjunction

with the operating method.

c. This “front–ending” of income under the direct financing method may

explain why lessors—unlike lessees—have never seriously opposed the

property rights approach to lease accounting.

3. Other favorable financial statement effects under the direct financing method:

a. The lessor’s rate of return on gross asset ratio is usually improved in the early

years of a particular lease. (This effect reverses as the lease grows older.)

b. The current ratio is also improved since the principal reduction over the

next 12 months is classified as a current asset.

IV. ADDITIONAL LEASING ASPECTS:

A. A sale and leaseback condition exists when one company sells an asset to another

company and immediately leases it back.

1. This is done as a way to finance asset acquisition and/or for tax reasons.

2. The lessee can treat the entire annual rental as a deductible expense for tax

purposes.

a. For example, the sale and leaseback of a building and land results in the

deduction for tax purpose of the entire lease payment.

b. If the lessee had continued to own the property, it could deduct depreciation

Financial Reporting and Analysis 6e Financial Reporting for Leases

only for the building itself, but not for the land on which the building is

located.

c. The cash infusion may help meet cash flow needs.

3. Treatment of the difference between the sale price and the carrying value of the asset

on the lessee’s books is treated as a deferred gain and is amortized into income

using the same rate and life that is used to amortize the asset itself.

a. If the lease is an operating lease to the lessee, the gain is amortized in

proportion to the rental payment.

b. The lessee immediately recognizes any loss.

3. Sale and leaseback accounting cannot be used when the seller-lessee retains some of

the risks and rewards of ownership since it is not consistent with a “sale.”

B. Other Special Lease Accounting Rules:

1. Leveraged leases and leases involving real estate require specialized accounting

rules.

C. Financial Reporting versus Tax Accounting for Leases: The U.S. income tax

rules also distinguish between operating and capital leases.

The tax criteria for differentiating them are not the same as the GAAP criteria.

1. Lessees prefer the capital lease approach because it accelerates recognition of

expense and thereby lowers the discounted present value of their tax liability.

2. Lessors prefer the operating lease approach on the tax return because it delays

recognition of revenues and lowers the present value of the tax liability.

3. Synthetic leases allow lessees to achieve operating lease treatment for financial

purposes and capital lease treatment for tax purposes.

D. Lessor’s disclosures:

1. Capital and operating leases must be disclosed separately.

2. A minimum lease payment schedule must be provided.

3. The components of the net investment in capital leases are delineated, as are the

cost and accumulated depreciation of assets under operating leases.

E. The criteria that trigger capital lease treatment are easily evaded. Operating leases

predominate in financial reporting, but the proportion of operating lease payments to

capital lease payments can vary greatly between firms in the same industry.

V. GLOBAL VANTAGE POINT

A. Comparison of IFRS and GAAP Lease Accounting: Accounting requirements under

International Accounting Standards (IAS) 17 – Leases are similar to those under ASC

840 except for the following key differences.

1. Classification criteria for both the lessee and lessor are different from the ASC 840

criteria with the classification depending on which party has the risks and rewards

of ownership. For IFRS, whether a lease is a finance lease or an operating lease

depends on the substance of the transaction rather than the form of the contract.

a. Instead of the ASC 840’s bright-line of 75% of the economic life, IAS 17

states “major part” and instead of 90% of fair value, IAS 17 states

“substantially all”.

b. When computing for the present value of minimum lease payments, the

lessee should use the implicit interest rate if knows whereas under ASC

840, the lessee should use the lower of the implicit rate or the incremental

borrowing rate.

c. Under IAS 17, the classification criteria for the lessor and lessee are the

Financial Reporting and Analysis 6e Financial Reporting for Leases

same; the two additional lessor criteria under ASC 840 are absent.

2. A second difference relates to the ability for lessees to classify some assets held

under leases as investment property.

3. The time interval for reporting (disclosure) is different. IAS 17 lessor

disclosures are similar to ASC 840 but combine the payments for years two

through five, as is done for lessees.

B. FASB and IASB Joint Exposure Draft: to improve lease accounting. In May 2013,

the FASB and IASB issued a jointly developed leasing exposure draft. They take the

property rights approach and would require lessees to treat leases as capital leases.

a. To obtain the initial present value of the leased asset, they use an implicit rate

or the incremental borrowing rate.

b. Lease terms will include renewal options if lessee has significant incentive to

renew

c. Lessees will include variable rental payments (tied to an index) in their

present value calculations.

d. Under FASB’s proposal, firms would discount these payments and place the

present values on the balance sheet as capital leases.

e. Although initial balance sheet effect is the same for all long-term leases,

subsequent changes to the balance sheet depend on whether the asset is

equipment or property. Equipment is defined as Type A leases, and property

leases are defined as Type B leases.

f. Accounting for Type A leases is the same as accounting for capital leases.

Accounting for Type B leases yields depreciation that is equal to the

difference between the lease payment and interest expense for the period.

g. The concept of Type B leases is controversial from theoretical, complexity,

and cost-benefit viewpoints.

h. The IASB exposure draft is nearly identical to the FASB’s proposal except

differences arise because both lessees and lessors have the ability to classify

some types of assets as investment property.

VI. APPENDIX: MAKING FINANCIAL STATEMENT DATA COMPARABLE BY

ADJUSTING FOR OFF-BALANCE SHEET LEASES

A. The most straightforward method for making lessees’ balance sheet data comparable is

to treat all leases as if they were capital leases. This is called constructive

capitalization.

B. If operating leases were treated as capital leases, the liability that would appear on the

balance sheet is the discounted present value of the total net minimum operating lease

payments.

1. A discount rate must be selected.

a. The weighted average discount rate for all capital lease commitments is

appropriate if it is disclosed.

b. The weighted average rate on outstanding interest bearing long-term debt

provides a reasonable estimate of the lease discount rate.

2. Estimating Payments Beyond Five Years:

a. Assume that the minimum lease payment five years out continues for the

number of years required to account for the aggregate amount.

b. Assume that the decline in the minimum lease payments over the next five years

continues during the years that are aggregated.

Financial Reporting and Analysis 6e Financial Reporting for Leases

C. Next, an estimate of the capital lease asset is required.

1. Assume that the liability and the asset continue, beyond lease inception, to be equal.

2. However, since lease assets are generally less than lease liabilities throughout the

life of the lease, a percentage of the liability can be attributed to the asset.

a. The relationship depends on the discount rate.

b. The relationship depends on the duration of the lease term.

Financial Reporting and Analysis 6e Financial Reporting for Leases

CHAPTER QUIZ

1. For a capital lease, the amount recorded initially by the lessee as a liability should normally:

a. Exceed the total of the minimum lease payments.

b. Exceed the present value of the minimum lease payments at the beginning of the lease.

c. Equal the total of the minimum lease payments.

d. Equal the present value of the minimum lease payments at the beginning of the lease.

2. Which of the following best characterizes how a corporation’s financial reporting affects a

firm’s decision to either lease or buy an asset?

a. A company with a high debt to equity ratio will structure a lease as an operating

lease to meet a loan covenant.

b. A company will want a lease classified as operating in order to raise the return on

assets ratio.

c. Special Purpose Entities (SPEs) are used to create an off-balance sheet asset along

with the corresponding liability by transferring lease obligations to related party

entities.

d. All of the above.

3. Which of the following factors favors the structuring of leases as operating?

a. Corporate bond covenants contain specific covenants relating to financial policies that

the firm must follow.

b. Lessee ownership is closely held so that risk reduction is important.

c. Lessee has a comparative advantage in reselling the asset.

d. The asset is not specialized to the lessee.

4. Assume a noncancellable lease beginning December 31, 2015, with annual minimum lease

payments of $10,000 made at the end of each year for four years. Ten percent is assumed to

be the appropriate interest rate. If the lease is treated as a capital lease, how is the annual

rental expense allocated between interest and principal over the life of the lease?

Interest Principal

a. $0 $40,000.

b. $8,300. $31,700.

c. $9,400. $30,600.

d. $10,500 $29,500.

5. What role do the lease capitalization criteria have in determining the period over which the

leased asset is depreciated?

a. The asset is always depreciated over the lease term.

b. The asset is always depreciated over its estimated economic life.

c. The asset is depreciated over its estimated economic life when one of the transfer of

ownership criteria is met.

d. The asset is depreciated over the lease term when one of the transfer of ownership

criteria is met.

Financial Reporting and Analysis 6e Financial Reporting for Leases

6. Assuming the same facts as in #4 above, which of the following best describes the

relationship between the balance sheet asset and liability attributable to the lease?

a. The net book value of the leased asset exceeds the carrying value of the lease obligation

during the lease term.

b. The carrying value of the lease obligation exceeds the net book value of the leased asset

during the lease term.

c. The net book value of the leased asset equals the carrying value of the lease obligation

during the lease term.

d. The net book value of the leased asset exceeds the carrying value of the lease obligation

only during the first two years of the lease term.

7. Assuming the same facts as in #4 above, which of the following best describes the income

statement effects of lease classification?

a. Total rent expense recorded under the operating lease classification exceeds total

expense recorded under the capital lease classification.

b. Total rent expense recorded under the capital lease classification exceeds total

expense recorded under the operating lease classification.

c. Total rent expense recorded under the operating lease classification equals total

expense recorded under the capital lease classification in each of the four years.

d. Total rent expense recorded under the capital lease classification exceeds total

expense recorded under the operating lease classification in the last two years of

the lease term.

8. What is the difference between a direct financing and a sales-type lease?

a. The difference between the sum of all lease payments and the cost of the leased

asset to the lessor is interest income for direct financing leases, and is part interest

and part sales income for sales-type leases.

b. Lessees usually depreciate the direct financing leases over the term of the lease and

sales-type leases over the useful life of the leased asset.

c. The lease payments receivable on the books of a lessor are recorded at their present

value for sales-type leases and at their gross value for direct financing leases.

d. The lessor records the present value of the residual value of the leased asset for

direct financing leases, but records the undiscounted (gross) residual value for

sales–type leases.

9. A lessor leased a machine for a 10-year period, which approximated the useful life of the

machine. The lessor purchased the machine for $160,000 and expects to earn a 10% return

on its investment, based on an annual rental of $23,672 payable in advance each January 1.

Assuming that the lease was a direct financing lease, calculate the amount of interest income

the lessee will record at the end of the first year of the lease.

a. $7,672.

b. $13,632.

c. $16,000.

d. $23,672.

Financial Reporting and Analysis 6e Financial Reporting for Leases

10. Assuming the same facts as in #9 above, what is the dollar amount of unearned interest

revenue at the lease inception?

a. $63,088.

b. $76,720.

c. $90,352.

d. $100,392.

QUIZ ANSWERS:

1. d. FASB ASC 840 requires that the lessee record a capital lease as an asset and a liability at

the present value of the minimum lease payments during the lease term. The discount rate

is the lower of the lessor’s implicit interest rate or the lessee’s incremental borrowing rate

of interest. The present value cannot exceed the fair value of the leased asset at the

inception of the lease.

Financial Reporting and Analysis 6e Financial Reporting for Leases

consent of McGraw-Hill Education.

amortization of the lease obligation. Also equals the

present value of the remaining minimum lease

payments.

5. c. Generally, depreciation methods used for similar purchased property are applied to leased

assets over their estimated economic lives when one of the transfer of ownership criteria is

met and over the lease term when one of the other capitalization criteria is satisfied.

6. b. Balance sheet effect of lease capitalization: December 31

2015 2016 2017 2018 2019

Assets

Leased assets 31,700 31,700 31,700 31,700 31,700

Accumulated depreciation 0 7,925 15,850 23,775 31,700

Leased assets, net 31,700 23,775 15,850 7,925 0

Liabilities

Current portion of lease obligation 6,830 7,513 8,265 9,092 0

Long–term debt: lease obligation 24,870 17,357 9,092 0 0

31,700 24,870 17,357 9,092 0

The gross and net (of accumulated depreciation) amounts are reported at each balance sheet

date. The current and noncurrent components of the lease obligation are reported as

liabilities under capitalization. The current component is the principal portion of the lease

payment to be made in the following year. Note that, at the inception of the lease, the

leased asset and liability are equal at $31,700. Since the asset and liability are amortized

using different methods, this equality is not again observed until the end of the lease term

when both asset and liability are equal to zero.

7. d. Income statement effects of lease classification:

Operating Lease Capital Lease

Operating = Operating Non-operating

Total Expense Expense Expense Total

Year Rent Depreciation Interest Expense

2015 10,000 7,925 3,170 11,095

2016 10,000 7,925 2,487 10,412

2017 10,000 7,925 1,735 9,660

2018 10,000 7,925 909 8,834

40,000 31,700 8,300 40,000

Note that total expenses under both classifications are equal. However, the amounts

reported differ in each year, and in their presentation on the income statement (e.g.,

operating versus nonoperating).

8. a. A lessee accounts for both direct financing and sales-type leases as capital leases. The

difference between the two arises only for lessor accounting. In a direct financing lease, the

difference between the gross investment and its cost or carrying amount is recorded as

unearned interest revenue. No gross profit is recognized. In a sales-type lease, the same

amount of unearned interest revenue will be recorded. However, gross profit equal to the

difference between the cost (plus initial direct costs minus the present value of the

unguaranteed residual value) and the sales price is also recognized. The difference between

Financial Reporting and Analysis 6e Financial Reporting for Leases

consent of McGraw-Hill Education.

a direct financing lease and a sales-type lease is that the cost used in accounting for a direct

financing lease is ordinarily the fair value. The cost for a sales-type lease differs from the

fair value.

9. b. The annual $23,672 lease payment to the lessor is payable at the beginning of each

period. The first payment received reduces the lease investment by the full amount of the

payment, leaving a carrying value of $136,328 ($160,000 – $23,672) at the beginning of the

first year. Because the appropriate rate of return is 10%, interest earned in the first year is

$13,632 ($136,328 x 10%).

10. b. For a direct financing lease, a lessor should record the total amount of the minimum

lease payments, net of executory costs (10 x $23,672 = $236,720), plus any unguaranteed

residual value ($0) as the gross investment in the lease. In this case, cash must also be

debited and lease payments receivable credited for the first payment received at the lease

inception. The leased asset will be credited at its cost ($160,000), with the difference

between the initial gross investment and cost ($236,720 – $160,000 = $76,720) recorded as

unearned interest revenue.

RECOMMENDED EXHIBITS

Figure 12.1—Differences between Operating and Capital Leases

Figure 12.2—Lessees’ Accounting for Capital Leases

Figure 12.5 – Decision Tree for Lessor’s Treatment of Leases

Figure 12.6 – Detailed Explansion of Figure 12.5 – Decision Tree for Lessor’s Treatment of Leases

Exhibit 12.4 – Comparison of Undiscounted Dollar Magnitudes of Capital and Operating Lease

Payments