Choosing the Accounting Method
When a lessee treats a lease as a capital lease, it recognizes an asset and a liability, thereby increasing total liabilities and making the company appear riskier. Given a choice, most lessees prefer not to show the asset and a related liability on the balance sheet. For this reason, lessees prefer an operating lease to an installment purchase or a capital lease. Lessees also prefer to recognize expenses for financial reporting later rather than sooner. These preferences have led a number of lessees to structure asset acquisitions so that the financing takes the form of an operating lease, thereby achieving off-balance-sheet financing. U.S. GAAP provides detailed rules for accounting for long-term leases. The lessor and lessee must account for a lease as a capital lease if the lease meets any one of four conditions
These conditions attempt to identify which party, the lessor or the lessee, bears most of the risk related to the asset under lease. When the lessor bears most of the risk, the lease is an operating lease. When the lessee bears most of the risk, the lease is a capital lease.
A lease is a capital lease if it meets any one of the following conditions
When a lessee treats a lease as a capital lease, it recognizes an asset and a liability, thereby increasing total liabilities and making the company appear riskier. Given a choice, most lessees prefer not to show the asset and a related liability on the balance sheet. For this reason, lessees prefer an operating lease to an installment purchase or a capital lease. Lessees also prefer to recognize expenses for financial reporting later rather than sooner. These preferences have led a number of lessees to structure asset acquisitions so that the financing takes the form of an operating lease, thereby achieving off-balance-sheet financing. U.S. GAAP provides detailed rules for accounting for long-term leases. The lessor and lessee must account for a lease as a capital lease if the lease meets any one of four conditions
These conditions attempt to identify which party, the lessor or the lessee, bears most of the risk related to the asset under lease. When the lessor bears most of the risk, the lease is an operating lease. When the lessee bears most of the risk, the lease is a capital lease.
A lease is a capital lease if it meets any one of the following conditions
- If it extends for at least 75% of the asset’s total expected economic life (that is, the lessee uses the asset for most of its life).
- If it transfers ownership to the lessee at the end of the lease term (that is, the lessee bears the risk of changes in the residual value of the asset at the end of the lease term)
- If it seems likely the lessor will transfer ownership to the lessee because of a ‘‘bargain purchase’’ option (that is, the lessee again bears the residual value risk; a bargain purchase option gives the lessee the right to purchase the asset for a price less than the expected fair market value of the asset when the lessee exercises its option).
- The present value of the contractual minimum lease payments equals or exceeds 90% of the fair market value of the asset at the time of signing
The first three conditions are relatively easy to avoid in lease contracts if lessors and lessees prefer to treat a lease as an operating lease instead of a capital lease. The most difficult of the four conditions to avoid is the fourth. When the present value of the contractual minimum lease payments equal or exceed 90% of the fair market value ofthe asset at the time of signing, the lessor has less than or equal to 10% of the asset’s value at risk to an uncertain residual value at the end of the lease term. Therefore, the lease transfers the major risks and rewards of ownership from the lessor to the lessee. In economic substance, the lessee has acquired an asset and has agreed to pay for it under a long-term contract, which the lessee recognizes as a liability. When the present value of the minimum lease payments is less than 90% of the fair market value of the asset at the time of signing, the lessor bears the major risks and rewards of ownership and the lease is an operating lease
Firms often report both operating and capital leases because certain lease agreements meet one or more of these conditions while others do not. As an example of the significance of leasing activities, consider a typical firm in the airline industry that leases many of its aircraft and ground facilities. In Note 8 to its December 31, 2011, consolidated financial statements, Southwest Airlines provides schedules of capital and operating lease commitments, as shown in Exhibit 7.13. Southwest Airlines also reports $3,751 million of combined long-term debt and current maturities of longterm debt in its December 31, 2011, consolidated balance sheet. Note that the capitalized lease payments are not a large portion of Southwest’s long-term debt. Southwest’s commitments under operating leases (gross future cash flows of $5,583 million) are more substantial, representing an important off-balance-sheet cash flow commitment of the firm.
Converting Operating Leases to Capital Leases
Lease commitments by lessees accounted for as operating leases do not appear as assets or liabilities on the balance sheet and, if you believe these obligations are essentially financial commitments, can cause you to understate the short-term liquidity or long-term solvency risk of the firm. In cross-sectional comparisons of different firms, you may want to treat all leases as capital leases with the objective of making all firms more comparable in terms of assets and liabilities. Restating the financial statements of lessees in this way provides a more conservative measure of total liabilities.
Firms often report both operating and capital leases because certain lease agreements meet one or more of these conditions while others do not. As an example of the significance of leasing activities, consider a typical firm in the airline industry that leases many of its aircraft and ground facilities. In Note 8 to its December 31, 2011, consolidated financial statements, Southwest Airlines provides schedules of capital and operating lease commitments, as shown in Exhibit 7.13. Southwest Airlines also reports $3,751 million of combined long-term debt and current maturities of longterm debt in its December 31, 2011, consolidated balance sheet. Note that the capitalized lease payments are not a large portion of Southwest’s long-term debt. Southwest’s commitments under operating leases (gross future cash flows of $5,583 million) are more substantial, representing an important off-balance-sheet cash flow commitment of the firm.
Converting Operating Leases to Capital Leases
Lease commitments by lessees accounted for as operating leases do not appear as assets or liabilities on the balance sheet and, if you believe these obligations are essentially financial commitments, can cause you to understate the short-term liquidity or long-term solvency risk of the firm. In cross-sectional comparisons of different firms, you may want to treat all leases as capital leases with the objective of making all firms more comparable in terms of assets and liabilities. Restating the financial statements of lessees in this way provides a more conservative measure of total liabilities.
2016–2017. We assume the payments are evenly distributed. To convert these operating lease cash payments to a capital lease, you must discount the lease commitments to present value. The discount rate you should use is the lessee’s incremental borrowing rate for secured debt with similar risk to that of the leasing arrangement. PepsiCo’s interest expense (see the income statement) as a percentage of average short- and long-term borrowing for 2012 (see the balance sheet) is 3.3% {$899/[0.5($4,815 þ $23,544 þ $6,205 þ $20,568)]}. We assume a 4% rate to compute the present value of operating lease commitments.
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