Intermediate Accounting Kieso 11th Edition.doc

Intermediate AccountingEleventhEditionChapter21AccountingforLeasesDonaldE.Kieso JerryJ.Weygandt TerryD.WarfieldIntermediate Accountingby:DonaldE.Kieso,Ph.D.,C.P.A.KPMGPeatMarwickEmeritusProfessorofAccountingNorthernIllinoisUniversityDeKalb, IllinoisJerryJ.Weygandt,Ph.D.,C.P.A.ArthurAndersenAlumniProfessorofAccountingUniversityofWisconsinMadison, WisconsinTerryD.Warfield,Ph.D.AssociateProfessorUniversityofWisconsinMadison,WisconsinCopyright2004JohnWiley&Sons,Inc.Allrightsreserved. JohnWiley&Sons,Inc.111RiverSt.,6thFloor,Hoboken,NJ070300471072087iiTable of ContentsIntermediateAccountingTableofContentsBASICS OF LEASING. 3AdvantagesofLeasing. 3ConceptualNatureofaLease. 5ACCOUNTING BY LESSEE. 7CapitalizationCriteria. 8AssetandLiabilityAccountedforDifferently. 11CapitalLeaseMethod(Lessee). 12OperatingMethod(Lessee). 16ComparisonofCapitalLeasewithOperatingLease. 16ACCOUNTING BY LESSOR. 19EconomicsofLeasing. 19ClassificationofLeasesbytheLessor. 20Direct-FinancingMethod(Lessor). 22Operating Method (Lessor). 26SPECIAL ACCOUNTING PROBLEMS. 27ResidualValues. 27Sales-Type Leases (Lessor). 34BargainPurchaseOption(Lessee). 37InitialDirectCosts(Lessor). 38Current versus Noncurrent. 38DisclosingLeaseData. 40LEASE ACCOUNTINGUNSOLVED PROBLEMS. 43Illustrations of Lease Arrangements. 50HARMON, INC. 51ARDENS OVEN CO. 52MENDOTA TRUCK CO. 54APPLELAND COMPUTER. 55Sale-Leasebacks. 57DETERMINING ASSET USE. 58Lessee.58Lessor.59SALE-LEASEBACK ILLUSTRATION. 60iiiIntermediateAccountingTableofContentsivIntermediateAccountingChapter21More Companies Ask, “Why Buy?”Leasinghasgrowntremendouslyinpopularityandtodayisthefastest-growingformof capitalinvestment.Insteadofborrowingmoneytobuyanairplane,acomputer,anuclear core,orasatellite,acompanymakesperiodicpaymentstoleasetheasset.Eventhegambling casinosleasetheirslotmachines.Airlinesandrailroadsleasehugeamountsofequipment; manyhotelandmotelchainsleasetheirfacilities;andmostretailchainsleasethebulkof theirretailpremisesandwarehouses.Thepopularityofleasingisevidencedinthefactthat558of600companiessurveyedbytheAICPAin2001disclosedleasedata.1Aclassicexampleistheairlineindustry.ManytravelersonairlinessuchasUnited,Delta, andSouthwest believetheplanestheyareflyingareownedbytheseairlines.Butinmany cases,nothingcouldbefurtherfromthetruth.Herearerecentleasepercentagesforthe majorU.S.airlines.Whydoairlinecompaniesleasemanyoftheirairplanes?Onereasonisthefavorable accountingtreatmentthatairlinesreceiveiftheyleaseratherthanpurchase.Bynotreporting theairplaneandrelatedborrowingontheirbalancesheets,companieslowertheirdebtto equityratios.Inaddition,companiesthatleaseoftenreporthighernetincomeintheearlier yearsofthelifeoftheairplane.Page1IntermediateAccountingChapter21PREVIEW OF CHAPTER 21Becauseoftheincreasedsignificanceandprevalenceofleasearrangementsindicatedinthe openingstory,theneedforuniformaccountingandcompleteinformativereportingofthese transactionshasintensified.Inthischapter,wewilllookattheaccountingissuesrelatedto leasing.Thecontentandorganizationofthischapterareasfollows.Page2BASICS OF LEASINGIntermediateAccountingChapter21Study ObjectiveExplain the nature, economic substance, and advantages of lease transactions.Alease isacontractualagreementbetweenalessor andalessee thatgivesthelesseetheright tousespecificproperty,ownedbythelessor,foraspecifiedperiodoftimeinreturnforstipulated, andgenerallyperiodic,cashpayments(rents).Anessentialelementoftheleaseagreementis thatthelessorconveyslessthanthetotalinterestintheproperty.Becausealeaseisacontract,theprovisionsagreedtobythelessorandlesseemayvarywidely andmaybelimitedonlybytheiringenuity.Thedurationlease termoftheleasemaybe anythingfromashortperiodoftimetotheentireexpectedeconomiclifeoftheasset.Therental payments maybelevelfromyeartoyear,increasinginamount,ordecreasing.Theymaybe predeterminedormayvarywithsales,theprimeinterestrate,theconsumerpriceindex,orsome otherfactor.Inmostcasestherentissettoenablethelessortorecoverthecostoftheassetplus afairreturnoverthelifeofthelease.Theobligations for taxes, insurance, and maintenance (executorycosts)maybeassumedby eitherthelessororthelessee,ortheymaybedivided.Restrictions comparabletobondindentures maylimitthelesseesactivitiesregardingdividendpaymentsortheincurrenceoffurtherdebt andleaseobligationsinordertoprotectthelessorfromdefaultontherents.Theleasecontract maybenoncancelable,oritmaygranttherighttoearly termination onpaymentofasetscale ofpricesplusapenalty.Incaseofdefault,thelesseemaybeliableforallfuturepaymentsat once,receivingtitletothepropertyinexchange.Alternatively,incaseofdefault,thelessormay havetherighttoselltoathirdpartyandcollectfromthelesseealloraportionofthedifference betweenthesalepriceandthelessorsunrecoveredcost. Different treatments for the lessee at termination oftheleasemayrangefromnonetotheright topurchasetheleasedassetatthefairmarketvalueortherighttoreneworbuyatanominal price.Advantages of LeasingAlthoughleasingisnotwithoutitsdisadvantages,thegrowthinitsusesuggeststhatitoftenhas agenuineadvantageoverowningproperty.Someofthecommonlydiscussedadvantagestothe lesseeofleasingare:1.100% Financing at Fixed Rates. Leasesareoftensignedwithoutrequiringanymoney downfromthelessee,whichhelpsthelesseetoconservescarcecashanespecially desirablefeaturefornewanddevelopingcompanies.Inaddition,leasepaymentsoften remainfixed,whichprotectsthelesseeagainstinflationandincreasesinthecostofPage3IntermediateAccountingChapter21money.Thefollowingcommentregardingaconventionalloanistypical:“Ourlocal bankfinallycameupto80percentofthepurchasepricebutwouldntgoanyhigher, andtheywantedafloatinginterestrate.Wejustcouldntaffordthedownpayment andweneededtolockinafinalpaymentrateweknewwecouldlivewith.”2.Protection against Obsolescence. Leasingequipmentreducestheriskofobsolescence tothelessee,andinmanycasespassestheriskofresidualvaluetothelessor.For example,Merck (apharmaceuticalmaker)leasescomputers.Merckispermittedunder theleaseagreementtoturninanoldcomputerforanewmodelatanytime,canceling theoldleaseandwritinganewone.Thecostofthenewleaseisaddedtothebalance dueontheoldlease,lesstheoldcomputerstrade-invalue.Asonetreasurerremarked,“Ourinstinctistopurchase.”Butifanewcomputercomesalonginashorttime,“then leasingisjustaheckofalotmoreconvenientthanpurchasing.”3.Flexibility. Leaseagreementsmaycontainlessrestrictiveprovisionsthanotherdebt agreements.Innovativelessorscantailoraleaseagreementtothelesseesspecialneeds. Forinstance,rentalpaymentscanbestructuredtomeetthetimingofcashrevenues generatedbytheequipmentsothatpaymentsaremadewhentheequipmentis productive.4.Less Costly Financing. Somecompaniesfindleasingcheaperthanotherformsof financing.Forexample,start-upcompaniesindepressedindustriesorcompaniesin lowtaxbracketsmayleaseasawayofclaimingtaxbenefitsthatmightotherwisebe lost.Depreciationdeductionsoffernobenefittocompaniesthathavelittle,ifany, taxableincome.Throughleasing,thesetaxbenefitsareusedbytheleasingcompanies orfinancialinstitutions,whichcanpasssomeofthetaxbenefitsbacktotheuserofthe assetintheformoflowerrentalpayments.Somecompanies“doubledip”ontheinternationalleveltoo.Thatis,theleasing rulesofthelessorsandlesseescountriesmaybedifferent,permittingboth partiestobeanowneroftheasset.Thus,bothlessorandlesseereceivethetax benefitsrelatedtodepreciation.5.Tax Advantages. Insomecases,companiescan“havetheircakeandeatittoo.”That is,companiesdonotreportanassetoraliabilityfortheleasearrangementforfinancial reportingpurposes.However,fortaxpurposes,theassetiscapitalizedanddepreciated. Asaresult,thecompanytakesdeductionsearlierratherthanlaterandalsosaveson itstaxes.Acommonvehicleforthistypetransactionisa“syntheticlease”arrangement. AnexpandeddiscussionofasyntheticleaseusedbyKrispy Kreme isonpage1098.6.Off-Balance-Sheet Financing. Certainleasesdonotadddebtonabalancesheetor affectfinancialratios,andtheymayaddtoborrowingcapacity.2 Suchoff-balance-sheet financing iscriticaltosomecompanies.Page4IntermediateAccountingChapter21O FF-BALANCE-SHEET FINANCINGAsshowninouropeningstory,theairlinesuseleasearrangementsextensively,whichresults inagreatdealofoff-balance-sheetfinancing.Thefollowingchartindicatesthatdebtlevels areunderstatedbyasubstantialamountformanyairlinesthatleaseaircraft.Analystsmustadjustreporteddebtlevelsfortheeffectsofnon-capitalizedleases.Forexample, theestimatesforadditionaldebtinthechartabovewerederivedbytakingthepresentvalue ofeachairlinesfutureoperatingleasepayments,asdisclosedintheleasenoteinthe companysannualreport(asshowninIllustration32).AmethodologyformakingthisadjustmentisdiscussedinEugeneA.Imhoff,Jr.,RobertC. Lipe,andDavidW.Wright,“OperatingLeases:ImpactofConstructiveCapitalization,” Accounting Horizons (March1991).Conceptual Nature of a LeaseIfUnited Airlines borrows$47millionona10-yearnotefromNationalCityBanktopurchase aBoeing757jetplane,itisclearthatanassetandrelatedliabilityshouldbereportedonUniteds balancesheetatthatamount.IfUnitedpurchasesthe757for$47,000,000directlyfromBoeing throughaninstallmentpurchaseover10years,itisequallyclearthatanassetandrelatedliability shouldbereported(i.e.,theinstallmenttransactionshouldbe“capitalized”).However,ifUnited leases theBoeing757for10yearsthroughanoncancelableleasetransactionwithpaymentsof thesameamountastheinstallmentpurchasetransaction,differencesofopinionstarttodevelop overhowthistransactionshouldbereported.Thevariousviewsoncapitalization of leases are asfollows.1.Do Not Capitalize Any Leased Assets. Inthisview,becausethelesseedoesnothave ownershipoftheproperty,capitalizationisconsideredinappropriate.Furthermore, aleaseisan“executory” contract requiringcontinuingperformancebybothparties. Becauseotherexecutorycontracts(suchaspurchasecommitmentsandemployment contracts)arenotcapitalizedatpresent,leasesshouldnotbecapitalizedeither.Page5IntermediateAccountingChapter212.Capitalize Leases That Are Similar to Installment Purchases. Inthisview,transactions shouldbereportedinaccordancewiththeireconomicsubstance.Therefore,if installmentpurchasesarecapitalized,soalsoshouldleasesthathavesimilar characteristics.Forexample,UnitedAirlinesiscommittedtothesamepaymentsover a10-yearperiodforeitheraleaseoraninstallmentpurchase;lesseesmakerental payments,whereasownersmakemortgagepayments.Whyshouldntthefinancial statementsreportthesetransactionsinthesamemanner?3.Capitalize All Long-Term Leases. Underthisapproach,theonlyrequirementfor capitalizationisthelong-termrighttousetheproperty.Thisproperty-rightsapproach capitalizesalllong-termleases.34.Capitalize Firm Leases Where the Penalty for Nonperformance Is Substantial. Afinal approachistocapitalizeonly“firm”(noncancelable)contractualrightsandobligations.“Firm”meansthatitisunlikelythatperformanceundertheleasecanbeavoided withoutaseverepenalty.4Theissueofhowtoreportleasesistheclassiccaseofsubstanceversusform. Althoughlegaltitledoesnottechnicallypassinleasetransactions,thebenefits fromtheuseofthepropertydotransfer.Inshort,thevariousviewpointsrangefromnocapitalizationtocapitalizationofallleases.The FASBapparentlyagreeswiththecapitalizationapproachwhentheleaseissimilartoaninstallment purchase,notingthata lease that transfers substantially all of the benefits and risks of property ownership should be capitalized.Transferofownershipcanbeassumedonlyifthereisahigh degreeofperformancetothetransferthatis,iftheleaseisnoncancelable.Noncancelable means thattheleasecontractiscancelableonlyupontheoutcomeofsomeremotecontingency,orthat thecancellationprovisionsandpenaltiesofthecontractaresocostlytothelesseethatcancellation probablywillnotoccur.Onlynoncancelableleasesmaybecapitalized.Thisviewpointleadstothreebasicconclusions:(1)Thecharacteristicsthatindicatethat substantiallyallofthebenefitsandrisksofownershiphavebeentransferredmustbeidentified.(2)Thesamecharacteristicsshouldapplyconsistentlytothelesseeandthelessor.(3)Thoseleases thatdo not transfersubstantiallyallthebenefitsandrisksofownershipareoperatingleases. Theyshouldnotbecapitalizedbutratheraccountedforasrentalpaymentsandreceipts.Page6IntermediateAccountingChapter21ACCOUNTING BY LESSEEStudy ObjectiveDescribe the accounting criteria and procedures for capitalizing leases by the lessee.Ifalesseecapitalizes alease,thelessee recordsanassetandaliabilitygenerallyequaltothe presentvalueoftherentalpayments.Thelessor,havingtransferredsubstantiallyallthebenefits andrisksofownership,recognizesasalebyremovingtheassetfromthebalancesheetand replacingitwithareceivable.Thetypicaljournalentriesforthelesseeandthelessor,assuming equipmentisleasedandiscapitali