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A lease is a contractual agreement between a lessor and a lessee that gives the lessee the right to use specific property, owned by the lessor, for a specified period of time. In return for this right, the lessee agrees to make rental payments over the lease term to the lessor.
3. The lessors that own property include banks, captive leasing companies, and independents.
Advantages of Leasing
4. In discussing the advantages of leasing arrangements, advocates point out that leasing allows for: (a) 100% financing at fixed rates, (b) protection against obsolescence, (c) flexibility, (d) less costly financing, (e) tax advantages, and (f) off-balance-sheet financing.
5. A variety of opinions exist regarding the manner in which certain long-term lease arrange¬ments should be accounted for. These opinions range from total capitalization of all long-term leases to the belief that leases represent executory contracts that should not be capitalized. The FASB requires capitalization of lease arrangements that are similar to installment purchases. In short, lease arrangements that transfer substantially all of the risks and rewards of ownership of property should be capitalized by the lessee.
Lessee Accounting – Capitalization Criteria
6. (L.O. 2) For accounting purposes of the lessee, all leases may be classified as operating leases or capital leases. For a lease to be recorded as a capital lease, the lease must be noncancelable and meet one of the following four criteria:
a. The lease transfers ownership of the property to the lessee at the end of the lease.
b. The lease contains a bargain-purchase option.
c. The lease term is equal to 75% or more of the estimated economic life of the leased property.
d. The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90% of the fair value of the leased property.
If the lease meets none of the four criteria, the lease should be classified and accounted for as an operating lease.
7. A bargain purchase option is a provision allowing the lessee to purchase the leased property for a price that is significantly lower than the property’s expected fair value at the date the purchase option becomes exercisable. The 75% of economic life test is based on the belief that when a lease period equals or exceeds 75% of the asset’s economic life, the risks and rewards of ownership are transferred to the lessee and capitalization is appropriate. The reason for the recovery of investment test (90%) is that if the present value of the minimum lease payments are reasonably close to the market price of the asset, the asset is effectively being purchased. A major exception to the 75% and 90% rules is when the inception of the lease occurs during the last 25% of the asset’s life. When this occurs the 75% and 90% tests should not be used.
Capital Leases for Lessees
8. Under the capital lease method, the lessee treats the lease transaction as if an asset is being purchased over time (installment basis). For a capital lease, the lessee records an asset and a liability at the lower of (a) the present value of the minimum lease payments during the term of the lease or (b) the fair value of the leased asset at the inception of the lease. In determining the present value of the minimum lease payments, three important concepts are involved: (a) minimum lease payments, (b) executory costs, and (c) the discount rate.
9. Minimum lease payments include (a) minimum rental payments, (b) any guaranteed residual value, (c) penalty for failure to renew or extend the lease, and (d) any bargain- purchase option. Minimum rental payments are the minimum payments the lessee is obligated to make to the lessor under the lease agreement. A residual value is the estimated fair value of the leased property at the end of the lease term. The guaranteed residual value is (a) the certain or determinable amount at which the lessor has the right to require the lessee to purchase the asset, or (b) the amount the lessee or the third-party guarantor guarantees the lessor will realize. This allows the lessor to transfer the risk of loss in the fair value of the asset to the lessee.
10. If the lessee guarantees the residual value, the present value of this residual value should be reported as part of the lease liability. If a bargain purchase option exists instead of
a guaranteed residual value, the lessee should increase the present value of the minimum lease payments by the present value of the option price. In both the guaranteed residual value and the bargain purchase option cases, the lessee is committed to making these payments, and therefore the payments should be reported as an increase to the lease