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Accounting for leases.

Accounting for Leases

The acquisition and use of property is often accomplished through leasing arrangements. A lessor owns the property and transfers the right to use the property to a lessee who in turn pays rent for this privilege.

There are many economic advantages to leasing. A lessee can acquire equipment with no down payment and in that manner cover any cash flow problems. A lessee can acquire the latest equipment without any ownership risk and can avoid borrowing in order to purchase an asset and thereby maintain a low debt-to-equity ratio. A lessor may increase sales by offering a lease-purchase option. A lessor may retain the asset and take advantage of any residual value for future lease arrangements or for future sales. And both the lessor and lessee can structure the lease in order to obtain the best tax advantages for both.

Historically, leases have been accounted for as simple rental agreements. However, some leases are very similar to a debt financed purchase of property. In order to present a fair financial statement, the accounting profession has spent considerable time reviewing the problem and looking at the economic substance of a lease arrangement rather than its legal form. For example, Data Company decides to update its computer equipment. They decide on a new computer for $50,000. The computer has a useful life of five years with no residual value. Data Company can purchase the computer by means of a five-year, 12% note with principal and interest to be paid in five equal installments. As an alternative, Data Company can lease the computer for five years and make five equal rental payments. In substance these two transactions are the same although their legal form is quite different. Leasing can therefore become a means of keeping debt off the balance sheet.

The FASB has set up standards through FASB 13, 91 and 98 to clarify the reporting requirements for leases. Leases are initially divided into two types. The first of these are operating leases which are simple rental contracts. In this case, the lessor recognizes periodic rent as income and the lessee recognizes the rent as expense. The lessor retains ownership and generally handles all expenses such as maintenance, insurance and is entitled to the depreciation on the asset. The second type of lease is a capital lease. There are specific criteria which define a capital lease. The first four criteria apply to both the lessee and the lessor. There are two additional criteria which apply to the lessor only. If any of the first four criteria apply, then the lessee must treat the lease as a capital lease. For the lessor, any one of the first four must apply along with both of the remaining criteria.

Capital Lease for Both Lessee and Lessor (Any one may apply)

1. The lease transfers ownership of

the property to the lessee at the

end of the lease term. 2. The lease contains a bargain purchase

option. 3. The lease term is equal to 75% of

the total economic life of the

leased property. 4. The present value of the minimum

lease payments is at least

90% of the fair market value of

the property.

Additional Requirements for Lessor (Both must apply)

5. Collection of the minimum lease

payments must be reasonably assured. 6. No important uncertainties

surround the amount of

nonreimbursable costs yet to be

incurred by the lessor.

The transfer of ownership criterion is straightforward. If the lease agreement contains a clause which transfers ownership at the end of the lease term, the criterion has been met. The bargain purchase option allows the lessee to purchase the asset at a reduced price at the end of the lease. Although this sounds like a fairly simple concept, it does require estimating the fair market value at the end of the lease to determine just what a bargain price would be. The third criterion is met if the lease term covers at least 75% of the economic life of the asset. The term of the lease is defined to include renewal periods if renewal is assured. Here again, we are dealing with estimates. An exception is made for used assets which are near the end of their economic life. The criterion is not applicable for assets during the last 25% of their economic life, nor is it applicable for land which has an unlimited life. The fourth criterion considers the fair market value of the asset. If the present value of the lease payments equals at least 90% of the fair market value, then this criterion is met. Again we are dealing with estimates which can be problematical.

The two criteria which apply only to the lessor are also fairly straightforward. The first simply states that the collection of the lease payments be reasonably assured, and the second requires substantial completion on the part of the lessor. It assumes that all future costs of the lessor which are not to be reimbursed by the lessee are known at the beginning of the lease. Examples of this type of future cost would be uncertainties related to the completion of the construction of the leased asset or uncertainties related to an unusual warranty against obsolescence.

For the lessor, a capital lease is broken down into two further categories; a sales type lease or a direct financing lease. A direct financing lease is one where the cost of the asset is the same as its selling price. The only income recognized by the lessor is the interest on the lease receivable. Interest is calculated at the lessor's implicit borrowing rate. At the inception of the lease, the lessor removes the cost of the asset from the books and records a lease receivable. As each rental payment is received, the lessor recognizes interest income and also reduces the amount of the lease receivable. This is generally the situation when rental arrangements are made with a leasing company. For a sales-type lease, the selling price is more than the cost of the asset and a sale is recognized by the lessor at the inception of the lease. In this case the lessor recognized an initial gain based on the difference between the selling price and the cost. Interest income is then recognized with each rental payment in the same manner as described above. This type of lease is more frequently used by a dealer who sells as well as leases equipment. (Note: To calculate interest payments, the lessee is required to use the lower of: (1) his incremental borrowing rate or (2) the implicit borrowing rate of the lessor, if known. The lessee's incremental borrowing rate is the rate that the lessee would have incurred to borrow the funds necessary to purchase the asset.)

Let's consider the lease agreement in Table 1 in order to illustrate the accounting for a capital lease which is a direct financing lease for the lessor. Using the appropriate tables, we can determine that the present value of the lease is $250,194. The entries made by the lessee and lessor are shown in Table 2. [Tabular Data Omitted]

We have considered the basics of accounting for leases. There is much more to be discussed including financial statement reporting and disclosures, and we have not yet considered bargain purchase options, residual value or sale-leaseback arrangements. These topics will be addressed in future columns.
COPYRIGHT 1991 National Society of Public Accountants
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Author:Schwartz, Marlyn A.
Publication:The National Public Accountant
Date:Aug 1, 1991
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