How to define a lease?
A lease is a contractual agreement between the lessor (the owner of the property) and the lessee (the user of property) that gives the lessee the right to use the lessor’s property for a specific period of time in exchange for stipulated cash payments. Accounting for leases has long been a controversial subject. The basic controversy centers on the classification and accounting for capital leases are essentially equivalent to installment purchases.
Types of leases
From the lessee’s point of view, there are two types of leases: operating leases and capital leases. The distinction between them is important because a different accounting treatment is required for each. Thus there are the substantial balance sheet and income statement effects based on whether a lease is classified as a capital or an operating lease.
According to FASB Statement No. 13, Accounting for Leases, a lease should be classified as a capital lease if the lease meets one or more of the following criteria:
- The lease transfers ownership of the property to the lessee at the end of the lease term.
- The lease contains a purchase option (the asset can be purchased by the lessee at a price lower than its fair market value).
- The lease term is 75 percent or more of the leased property’s estimated economic life.
- The present value of the minimum lease payments is 90 percent or more of the fair market value of the property to the lessor at the inception of the lease.
Thus, capital leases are accounted for as essentially purchases of equipment or other property. A lease rather than a bank loan is used to finance the purchase. As we will see, accounting for these types of leases requires that the asset and the liability be recorded on the lessee’s books just as if a purchase had taken place.
A lease that does not meet any of the above criteria is considered an operating lease. With this type of lease, the lessor retains control and ownership of the property, which subsequently reverts back to the lessor at the end 0f the lease term. Accounting for this type of lease requires only that the lessee record an expense for the periodic lease payments as they are made. You should keep in mind that these two types of leases are not alternatives for the Same transaction. If the terms of the lease agreement meet any of the previously enumerated four criteria, the lease must be accounted for as a capital lease.
Accounting for Leases
To demonstrate the proper accounting for leases, assume that on January 2, 2019, the Scully Corporation enters into a lease with the Porter Company in which the Scully Corporation agrees to lease a piece of equipment for 5 equal annual payments of $13,850. Each payment is made at year-end (Most lease payments are made monthly. However, we are assuming annual payments for ease of illustration). In order to compare and contrast the accounting treatment for operating and capital leases, we will use this data to demonstrate the accounting procedures for each type of lease. This is for illustrative purposes only, however, because the lease must be considered either a capital lease or an operating lease.
Accounting for Operating Leases
Assuming this agreement is an operating lease, the Scully Corporation does not make any entry on January 2, 2019, when the lease agreement is signed. At this point, the lease is considered just an agreement or contract that neither party has yet carried out. The Scully Corporation makes the following entry on December 31 of each of the next five years:
The entire lease payment is shown as an expense. The equipment is still on the books of the lessor and is depreciated by the lessor. Over the 5-year lease term, the Scully Corporation incurs total lease expenses of $69,350, or $13,870 x 5 years.
Accounting for Capital Leases
Under a capital lease, the Scully Corporation actually records the equipment as an asset and the required lease payments as a liability. The asset and liability are recorded at the present value of the required lease payments by using an appropriate interest rate which we will assume is 12% for this lease. Subsequently, the Scully Corporation makes the yearly payments which are divided between principal and interest and also depreciates the equipment. In a corresponding manner, the lessor takes the leased equipment off his or her books and records a receivable at the present value of the lease payments.
The present value of the lease payments of $13,870 based on an interest rate of 12% is $50,000 (This is determined by discounting the annuity of $13,870 for 5 years at 12%). Based on this data, the Scully Corporation makes the following entry at January 2, 2019, the inception of the lease:
The account Leased Equipment under Capital Lease is a noncurrent asset, generally shown under the property, plant, and equipment section. The account Obligation under Capital Lease is a liability, of which part is classified as current and which part as long term.
At the end of each year, the Scully Corporation makes a $13,870 annual payment. The following table shows how these payments are divided between interest and principal:
The interest each year is based on 12% of the balance of the lease obligation at the beginning of the year. Thus, in 2019 interest is $6,000, or 12% of $50,000, and in 2020 it is $5,056, or 12% of $42,130. ‘The difference between the annual lease payment and the interest portion is the principal portion. The entry to record the first payment is:
The Scully Corporation needs to make one additional entry each year to record depreciation expense on the leased equipment. The leased equipment is depreciated over its life of five years using straight-line depreciation and no salvage value. Thus the Scully Corporation makes the following adjusting entry at the end of each year:
Operating versus Capital Leases
The following table shows the difference between accounting for this lease as an operating lease or as a capital lease. Over the entire 5-year period the total expense in both cases is $69,350, which represents the total cash outflows. However, each method results in a different expense pattern within a five-year period of time. In the first three years, the capital lease method results in a higher annual expense than does the operating lease method. This means that annual net income is lower in these years. This pattern then reverses in the last two years of the lease term.
These relationships lie at the heart of the controversy over the accounting for leases. Prior to the issuance of Statement 13, companies had a good deal of latitude in deciding whether a lease should be classified as an operating or a capital lease. Most companies felt that it was in their best interest to classify as many leases as possible as operating leases, and some obvious purchases that were being financed through leases were considered operating leases when they should have been considered capital leases.
If a lease is considered to be an operating lease, no liability is recorded on the balance sheet for the required lease payments, This means that the lessee’s working capital position or current ratio is not affected by the lease agreement. Remember that if a liability was recorded on a balance sheet, the next year’s payment would have to be considered a current liability, whereas the entire balance in the account Leased Equipment under Capital Lease is considered a noncurrent asset.
The fact that the lessee was in substance making an installment purchase but did not have to record the asset or liability on the balance sheet is referred to as off balance sheet financing. Off balance sheet financing also has a tendency to decrease a firm’s debt-to-equity ratio and to increase its return on investment. Furthermore, the annual expense associated with an operating lease is less in the first few years of the lease term than that with a capital lease. Because of these facts and the fear that creditors might react adversely if leases were capitalized on the balance sheet, some managers had a definite bias to classify leases as operating leases.
The criteria set forth in Statement 13 corrected a number of obvious situations in which agreements that were in substance capital leases were being accounted for as operating leases. The four criteria in this Statement ensure that leases that are in fact installment purchases are recorded as capital leases. Thus, the appropriate asset and liability, interest expense, and depreciation are recorded. In addition, current accounting rules require substantial footnote disclosure concerning lease terms and agreements.