Lease Classification and Reporting
A lessee (the party leasing the asset) classifies and accounts for a lease as a capital lease if, at its inception, the lease meets any of four criteria: (1) the lease transfers ownership of the property to the lessee by the end of the lease term; (2) the lease contains an option to purchase the property at a bargain price; (3) the lease term is 75% or more of the estimated economic life of the property; or (4) the present value of the minimum lease payments (MLPs) at the beginning of the lease term is 90% or more of the fair value of the leased property. A lease can be classified as an operating lease only when none of these criteria are met. Companies often effectively structure leases so that they can be classified as operating leases.
When a lease is classified as a capital lease, the lessee records it (both asset and liability) at an amount equal to the present value of the minimum lease payments over the lease term (excluding executory costs such as insurance, maintenance, and taxes paid by the lessor that are included in the MLP). The leased asset must be depreciated in a manner consistent with the lessee’s normal depreciation policy. Likewise, interest expense is accrued on the lease liability, just like any other interest-bearing liability. In accounting for an operating lease, however, the lessee charges rentals (MLPs) to expense as they are incurred; and no asset or liability is recognized on the balance sheet. The accounting rules require that all lessees disclose, usually in notes to financial statements: (1) future minimum lease payments separately for capital leases and operating leases for each of the five succeeding years and the total amount thereafter, and (2) rental expense for each period that an income statement is reported
Accounting for Leases An Illustration
This section compares the effects of accounting for a lease as either a capital or an operating lease. Specifically, we look at the effects on both the income statement and thebalance sheet of the lessee given the following information:
A lessee (the party leasing the asset) classifies and accounts for a lease as a capital lease if, at its inception, the lease meets any of four criteria: (1) the lease transfers ownership of the property to the lessee by the end of the lease term; (2) the lease contains an option to purchase the property at a bargain price; (3) the lease term is 75% or more of the estimated economic life of the property; or (4) the present value of the minimum lease payments (MLPs) at the beginning of the lease term is 90% or more of the fair value of the leased property. A lease can be classified as an operating lease only when none of these criteria are met. Companies often effectively structure leases so that they can be classified as operating leases.
When a lease is classified as a capital lease, the lessee records it (both asset and liability) at an amount equal to the present value of the minimum lease payments over the lease term (excluding executory costs such as insurance, maintenance, and taxes paid by the lessor that are included in the MLP). The leased asset must be depreciated in a manner consistent with the lessee’s normal depreciation policy. Likewise, interest expense is accrued on the lease liability, just like any other interest-bearing liability. In accounting for an operating lease, however, the lessee charges rentals (MLPs) to expense as they are incurred; and no asset or liability is recognized on the balance sheet. The accounting rules require that all lessees disclose, usually in notes to financial statements: (1) future minimum lease payments separately for capital leases and operating leases for each of the five succeeding years and the total amount thereafter, and (2) rental expense for each period that an income statement is reported
Accounting for Leases An Illustration
This section compares the effects of accounting for a lease as either a capital or an operating lease. Specifically, we look at the effects on both the income statement and thebalance sheet of the lessee given the following information:
- A company leases an asset on January 1, 2005it has no other assets or liabilities.
- Estimated economic life of the leased asset is five years with an expected salvage value of zero at the end of five years. The company will depreciate this asset on a straight-line basis over its economic life.
- The lease has a fixed noncancellable term of five years with annual minimum lease payments of $2,505 paid at the end of each year.
- Interest rate on the lease is 8% per year.
We begin the analysis by preparing an amortization schedule for the leased asset as shown in Exhibit 3.3. The initial step in preparing this schedule is to determine the present (market) value of the leased asset (and the lease liability) on January 1, 2005.Using the interest tables near the end of the book, the present value is $10,000 (computed as 3.992 $2,505). We then compute the interest and the principal amortization for each year. Interest equals the beginning-year liability multiplied by the interest rate (for year 2005 it is $10,000 0.08). The principal amount is equal to the total payment less interest (for year 2005 it is $2,505 $800). The schedule reveals the interest pattern mimics that of a fixed-payment mortgage with interest decreasing over time as the principal balance decreases. Next, we determine depreciation. Because this company uses straight line, the depreciation expense is $2,000 per year (computed as $10,000/5 years).We now have the necessary information to examine the effects of this lease transaction on both the income statement and balance sheet for the two alternative lease accounting methods.
Let’s first look at the effects on the income statement. When a lease is accounted for as an operating lease, the minimum lease payment is reported as a periodic rental expense. This implies a rental expense of $2,505 per year for this company. However
when a lease is accounted for as a capital lease, the company must recognize both periodic interest expense (see the amortization schedule in Exhibit 3.3) and depreciation expense ($2,000 per year in this case). Exhibit 3.4 summarizes the effects of this lease transaction on the income statement for these two alternative methods. Over the entire five-year period, total expense for both methods is identical. However, the capital lease method reports more expense in the earlier years and less expense in later years. This is due to declining interest expense over the lease term. Consequently, net income under the capital lease method is lower (higher) than under the operating lease method in the earlier (later) years of a lease.
when a lease is accounted for as a capital lease, the company must recognize both periodic interest expense (see the amortization schedule in Exhibit 3.3) and depreciation expense ($2,000 per year in this case). Exhibit 3.4 summarizes the effects of this lease transaction on the income statement for these two alternative methods. Over the entire five-year period, total expense for both methods is identical. However, the capital lease method reports more expense in the earlier years and less expense in later years. This is due to declining interest expense over the lease term. Consequently, net income under the capital lease method is lower (higher) than under the operating lease method in the earlier (later) years of a lease.
We next examine the effects of alternative lease accounting methods on the balance sheet. First, let’s consider the operating lease method. Because this company does not have any other assets or liabilities, the balance sheet under the operating lease method shows zero assets and liabilities at the beginning of the lease. At the end of the first year, the company pays its MLP of $2,505, and cash is reduced by this amount to yield a negative balance. Equity is reduced by the same amount because the MLP is recorded as rent expense. This process continues each year until the lease expires. At the end of the lease, the cumulative amount expensed, $12,525 (as reflected in equity), is equal to the cumulative cash payment (as reflected in the negative cash balance). This amount also equals the total MLP over the lease term as seen in Exhibit 3.3. Let’s now examine the balance sheet effects under the capital lease method (see Exhibit 3.5). To begin, note the balance sheet at the end of the lease term is identical under both lease methods. This result shows that the net accounting effects under the two methods are identical by the end of the lease. Still, there are major yearly differences before the end of the lease term. Most notable, at the inception of the lease, an asset and liability equal to the present value of the lease ($10,000) is recognized under the capital lease method. At the end of the first year (and every year), the negative cash balance reflects the MLP, which is identical under both lease methods—recall that alternative accounting methods do not affect cash flows.
For each year of the capital lease, the leased asset and lease liability are not equal, except at inception and termination of the lease. These differences occur because the leased asset declines by the amount of depreciation ($2,000 annually), while the lease liability declines by the amount of the principa amortization (for example, $1,705 in year 2005, per Exhibit 3.3). The decrease in equity in year 2005 is $2,800, which is the total of depreciation and interest expense for the period (see Exhibit 3.4). This process continues throughout the lease term. Note the leased asset is always lower than the lease liability during the lease term. This occurs because accumulated depreciation at any given time exceeds the cumulative principal reduction.
This illustration reveals the important impacts that alternative lease accounting methods can have on financial statements. While the operating lease method is simpler, the capital lease method is conceptually superior, both from a balance sheet and an income statement perspective. From a balance sheet perspective, capital lease accounting recognizes the benefits (assets) and obligations (liabilities) that arise from a lease transaction. In contrast, the operating lease method ignores these benefits and obligations and fully reflects these impacts only by the end of the lease term. This means the balance sheet under the operating lease method fails to reflect the lease assets and obligations of the company.
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