# Financial Accounting, v. 2.0

by Joe Hoyle and C.J. Skender

## 15.1 Accounting for Leases

### Learning Objectives

At the end of this section, students should be able to meet the following objectives:

1. Understand the theoretical difference between an operating lease and a capital lease.
2. Recognize that a lessee will be required to account for a lease as either an operating lease or a capital lease based on the specific terms of the contract.
3. Understand the concept of off-balance sheet financing.
4. Explain the term “substance over form” and how it applies to the financial reporting of a capital lease.

## Reporting a Liability for Leased Property

Question: Notes and bonds payable serve as the predominant source of long-term financing in the United States. Virtually all companies raise significant sums of money by incurring debts of this type. However, a quick perusal of the balance sheets of most well-known companies finds a broad array of other noncurrent liabilities, some of staggering size.

• Sears Holdings Corporation disclosed long-term capital lease obligations of $597 million as of January 29, 2011. • Southwest Airlines Co. reported deferred income tax liabilities of approximately$2.5 billion on December 31, 2010.
• Alcoa Inc. at December 31, 2010, lists $2.6 billion in liabilities (slightly under 12 percent of the company’s total) labeled as accrued postretirement benefitsPromises such as pension payments, health care insurance coverage, and life insurance benefits made by employers to eligible employees to be received after the individuals reach a specified retirement age. (other than pensions). These noncurrent liabilities represent large amounts of debts that are different from traditional notes and bonds. Some understanding of these balances is necessary to comprehend the information being conveyed in a set of financial statements. The reporting of liabilities such as those above is explored in depth in upper-level financial accounting courses. However, a basic level of knowledge is essential for every potential decision maker, not just those individuals who chose to major in accounting in college. Lease liabilities will be explored first in this chapter. To illustrate, assume that the Abilene Company needs an airplane to use in its daily operations. Rather than buy this asset, Abilene leases one from a business that owns a variety of aircraft. The lease is for seven years at an annual cost of$100,000. A number of reasons might exist for choosing to lease rather than buy. Perhaps Abilene is able to negotiate especially good terms for the airplane because of the company’s willingness to commit to such a long period of time.

On the day that the lease is signed, should Abilene report a liability and, if so, is the amount just the first $100,000 installment, the$700,000 total of all payments, or some other figure? When a company leases an asset, how is the related liability reported?

Answer: The liability balance to be reported by the Abilene Company cannot be determined based purely on the information that is provided. When a lesseeA party that pays cash for the use of an asset in a lease contract. (the party that will make use of the asset) signs a lease agreement, the transaction is recorded in one of two ways based on the terms of the contract.

Possibility One—An Operating LeaseA rental agreement where the benefits and risks of ownership are not conveyed from the lessor to the lessee.. Abilene might have obtained the use of this airplane through an operating lease, a rental arrangement. If so, the liability recognized when the contract is signed is $100,000, only the amount due immediately. Upon payment, the reported debt is reduced to zero despite the requirement that six more installments have to be paid. In financial accounting, the future payments on an operating lease are viewed as a commitment rather than a liability. Thus, information about those payments is disclosed in the notes to the financial statements but not formally reported. Possibility Two—A Capital LeaseA rental agreement where the benefits and risks of ownership are conveyed from the lessor to the lessee so that both the asset and liability are reported initially by the lessee at the present value of the cash payments; for accounting purposes, it exists when one of four established criteria are met.. This transaction could also have met specific criteria for classification as a capital lease. That type of lease is viewed as the equivalent of Abilene buying the airplane. The initial liability recognized by Abilene is the present value of the$700,000, the entire amount of cash to be paid over these seven years. The present value is determined by the mathematical removal of a reasonable rate of interest.

### Test Yourself

Question:

A lessee signs a lease agreement so that a piece of property can be used for the specified period of time. From an accounting perspective, what are the two types of leases?

1. Fixed leases and variable leases
2. Operating leases and capital leases
3. Income leases and expenditure-based leases
4. Noncontractual leases and contractual leases

The correct answer is choice b: Operating leases and capital leases.

Explanation:

For the lessee, all leases are classified for financial reporting purposes as either a rental (an operating lease) or the equivalent of a purchase (a capital lease).

## Does a Lessee Prefer to Report an Operating or Capital Lease?

Question: The previous answer raises a number of immediate questions about lease accounting. Probably the first of these relates to the practical goal of officials who want to produce financial statements that make their company look as financially healthy as possible. A lease agreement can be reported as (a) an operating lease with only the initial payment recorded as a liability or (b) a capital lease where the present value of all payments (a much larger number) is shown as the liability.

Officials for the lessee must surely prefer to classify all leases as operating leases to reduce the reported debt total. In financial accounting, does a lessee not have a bias to report operating leases rather than capital leases?

Answer: The answer to this question is obviously “Yes.” If an option exists between reporting a larger liability (capital lease) or a smaller one (operating lease), officials for the lessee are inclined to take whatever measures necessary to classify each contract as an operating lease. This is not a choice such as applying FIFO or LIFO. The reporting classification is based on the nature of the agreement.

Thus, Abilene Company will likely attempt to structure the contract for this airplane to meet any designated criteria for an operating lease. Financial accounting is supposed to report events and not influence them. However, at times, authoritative reporting standards impact the method by which companies design the transactions in which they engage.

If the previous example is judged to be an operating lease, Abilene only reports an initial liability of $100,000 although legally bound by the agreement to pay a much larger amount. The term off-balance sheet financingDescription used for an obligation where an amount of money must be paid that is larger than the figure reported on the balance sheet; for a lessee, an operating lease provides an example of off-balance sheet financing. is commonly used when a company is obligated for more money than the reported debt. Operating leases are one of the primary examples of “off-balance sheet financing.” As mentioned at the start of this chapter, Sears Holdings Corporation reports noncurrent liabilities of about$597 million on January 29, 2011, in connection with capital leases. However, that obligation seems small in comparison to the amount to be paid by the company on its operating leases. As the notes to those financial statements explain, Sears has numerous operating leases (for the use of stores, office facilities, warehouses, computers and transportation equipment) that will require payment of over $5.3 billion in the next few years. Most of the debt for this additional$5.3 billion is “off the balance sheet.” In other words, the obligation is not included in the liability section of the company’s balance sheet. For an operating lease, the reported liability balance does not reflect the total obligation, just the current amount that is due.

### Test Yourself

Question:

A lessee is negotiating a new lease for a large piece of property. Which of the following is most likely to be true?

1. The lessee will try to structure this contract as an operating lease to take advantage of off-balance sheet financing.
2. The lessee will not care whether the contract is viewed as an operating lease or a capital lease.
3. The lessee will try to structure this contract as a capital lease to avoid the implications of off-balance sheet financing.
4. The lessee will structure the contract in whatever way is most convenient for the lessor (the actual owner of the property).

The correct answer is choice a: The lessee will try to structure this contract as an operating lease to take advantage of off-balance sheet financing.

Explanation:

The liability balance reported for an operating lease is only the amount currently due. For most leases, that is a relatively small amount. A lessee will typically prefer to create this type of lease so that the reported liability total is lower. The remainder of the obligation will not be recognized until it comes due. The ability to use accounting rules to omit some amount of debt is commonly known as off-balance sheet financing.

## Differentiating an Operating Lease from a Capital Lease

Question: For a lessee, a radical difference in reporting exists between operating leases and capital leases. Company officials prefer to report operating leases so that the amount of liabilities appearing on the balance sheet is lower. What is the distinction between an operating lease and a capital lease?

Answer: In form, all lease agreements are rental arrangements. One party (the lessor) owns legal title to property while the other (the lessee) rents the use of that property for a specified period of time. However, in substance, a lease agreement may go beyond a pure rental agreement. Financial accounting has long held that a fairly presented portrait of an entity’s financial operations and economic health is only achieved by looking past the form of a transaction to report the actual substance of what is taking place. “Substance over form” is a mantra often heard in financial accounting.

Over thirty years ago, U.S. GAAP was created (by FASB) to provide authoritative guidance for the financial reporting of leases. An official pronouncement released at that time states that “a lease that transfers substantially all of the benefits and risks incident to the ownership of property should be accounted for as the acquisition of an asset and the incurrence of an obligation by the lessee.” In simple terms, this standard means that a lessee can obtain such a significant stake in leased property that the transaction more resembles a purchase than it does a rental. If the transaction looks like a purchase, the accounting should be that of a purchase.

When the transaction is more like a purchase, it is recorded as a capital lease. When the transaction is more like a rental, it is recorded as an operating lease.

• Capital lease. The lessee gains substantially all the benefits and risks of ownership. Although legal form is still that of a lease arrangement, the transaction is reported as a purchase at the present value of the future cash flows.
• Operating lease. The lessee does not obtain substantially all the benefits and risks of ownership. The transaction is reported as a rental arrangement.

### Test Yourself

Question:

A lessee signs a contract with the word “LEASE” typed across the top. Which of the following statements is true?

1. Rental expense will be recognized over the life of this contract.
2. If this contract is accounted for as a capital lease, that is an example of reporting substance over form.
3. If this contract is accounted for as an operating lease, that is an example of reporting form over substance.
4. Because a formal legal document has been created, this lease must be reported as a capital lease.

The correct answer is choice b: If this contract is accounted for as a capital lease, that is an example of reporting substance over form.

Explanation:

Although this contract is in the form of a rental arrangement, it must be accounted for as a capital lease if it has the substance of a purchase. Accountants always want to record the substance of a transaction rather than its mere form. Without knowing the information provided in the contract, the accountant cannot determine whether rent expense is appropriate here (an operating lease) or if the arrangement is the equivalent of a purchase (a capital lease).

## Criteria for a Capital Lease

Question: A capital lease is accounted for as a purchase because it so closely resembles the acquisition of the asset. An operating lease is more like a rent. The lessee normally prefers to report all such transactions as operating leases to reduce the amount of debt shown on its balance sheet. How does an accountant determine whether a contract qualifies as a capital lease or an operating lease?

Answer: In establishing reporting guidelines in this area, FASB created four specific criteria to serve as the line of demarcation between the two types of leases. Such rules set a standard that all companies must follow. If any one of these criteria is met, the lease is automatically recorded by the lessee as a capital lease. In that case, both the asset and liability are reported as if an actual purchase took place.

Not surprisingly, accountants and other company officials study these four criteria carefully. They hope to determine how the rules can be avoided so that most of their new contracts are viewed as operating leases. Interestingly, in recent years, official groups here and abroad have been examining these rules to decide whether U.S. GAAP and IFRS will be revised so that virtually all leases are reported as capital leases. At this time, the final outcome of those deliberations remains uncertain. However, a serious limitation on the use of the operating lease category seems likely in the next few years.

Criteria to Qualify as a Capital Lease (only one must be met):

1. If the lease contract specifies that title to the property will be conveyed to the lessee by the end of the lease term, it is a capital lease. If legal ownership is to be transferred from lessorA party that receives cash for granting the use of owned property to a lessee through a lease contract. to lessee, the entire series of payments is simply a method devised to purchase the asset. From the beginning, the property was being acquired.
2. If the contract allows the lessee to buy the property at a specified time at an amount sufficiently below expected fair value (so that a purchase is reasonably assured), it is a capital lease. The availability of this bargain purchase option indicates, once again, that the true intention of the contract is the conveyance of ownership. The transaction is the equivalent of a purchase if the option price is so low that purchase by the lessee can be anticipated.
3. If the lease contract is for a term that is equal to 75 percent or more of the estimated life of the property, it is a capital lease. This criterion is different from the first two where the transaction was just a disguised purchased. Here, the lessee will never gain ownership. However, the lease is for such an extensive portion of the asset’s life that the lessee obtains a vast majority of its utility. Although the 75 percent standard is an arbitrary benchmark, no doubt can exist that the lessee will be the primary beneficiary of the property.
4. The fourth criterion is too complicated to cover in an introductory textbook. The general idea is that the lessee is paying approximately the same amount as would have been charged to buy the asset. Paying the equivalent of the purchase price (or close to it) indicates that no real difference exists between the nature of the lease transaction and an acquisition.

### Test Yourself

Question:

A lessee signs a three-year lease for $79,000 per year to gain use of a machine. The machine has an expected useful life of five years. At the end of this three-year period, the machine is expected to be worth$60,000. The lessee has the right to buy it at that time for $50,000. The required payments are not the equivalent of the acquisition value of this asset. Which of the following is true for the lessee? 1. The lease is a capital lease. 2. The lease is an operating lease. 3. The lease might be a capital lease but not enough information is available. 4. The lease will be an operating lease if one of the four criteria is met. Answer: The correct answer is choice c: The lease might be a capital lease but not enough information is available. Explanation: If one of the four criteria established by FASB is met, this lease is reported as a capital lease. One of the criteria is still in question. Is a$50,000 purchase option viewed as a bargain if the expected fair value is $60,000? Is the$10,000 discount sufficient so that purchase is reasonably assured? Although the rules are clear, those judgments can be extremely difficult to make in practice. Not enough information is provided here to determine whether this purchase option is a bargain.

### Key Takeaway

A lessee accounts for a lease contract as either an operating lease or a capital lease depending on the specific terms of the agreement. Officials working for the lessee will likely prefer the contract to qualify as an operating lease because a smaller liability is reported. Thus, the reporting of an operating lease is a common example of off-balance sheet financing because a significant portion of the contractual payments are not included as liabilities on the balance sheet. In contrast, for a capital lease, the present value of all future cash flows must be reported as a liability. To differentiate operating leases from capital leases, four criteria have been established within U.S. GAAP. If any one of these criteria is met, the lessee accounts for the transaction as a capital lease. Although still a lease in legal form, the contract is viewed as a purchase in substance and reported in that manner.