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Chapter 17:. Leases. LEASE. 29 May 2007. Lecture . The lease contract Evolution of lease accounting standards Economic consequences of lease capitalization. G4+1 proposal on leases IFRS . The Lease Contract is.
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Chapter 17: Leases
LEASE 29 May 2007 Lecture • The lease contract • Evolution of lease accounting standards • Economic consequences of lease capitalization. • G4+1 proposal on leases • IFRS
The Lease Contract is • A legal document conveying use of property for a fixed period of time in exchange for rent or other compensation • A conveyance because the lessee acquires an interest in property for a fixed period of time • A contract because the lessor promises the lessee quiet enjoyment of the property during the lease term in exchange for the promise of periodic payments
Legal Form of a Lease Contract • An executory (unperformed) contract • A lessor (legal owner) transfers possession of a leased asset to a lessee for a fixed period of time in exchange for a series of rents • A lessee’s performance is executory because future rents are due one period at a time
Purchase Arrangement vs. True Lease • Purchase arrangements include • outright cash sales • credit sales • installment sales, • secured credit sales • conditional sales • Title passes to the user of the property in all instances except leases and conditional sales
Leases and Conditional Sales • Title passes in a conditional sale when final payment is made, but this does not necessarily occur with a lease • Leases in which the title passes at the end of the lease term or in which a bargain purchase option exists are virtually the same as conditional sales with respect to legal ownership
Capitalization • Strong argument for capitalization can be made for leases that resemble conditional sales agreements • Capitalization of leases that are virtually conditional sales agreements ... consistent with the true legal nature of the transaction
Lease Capitalization • Lessee’s viewpoint, a lease must be accounted for as either • a rental agreement or • a purchase equivalent with debt financing • Lessor’s viewpoint, the transaction must be treated as either • a rental agreement or • a sale equivalent with debt financing (if it is a sales-type lease) or a loan equivalent (if it is a financing-type lease)
Accounting Policy • The heart of the policy is classification of leases as either • operating or • capital leases • Arguments against lease capitalization • verifiability • use of present value discounting techniques introduced less reliable accounting numbers into the financial statements
Capitalization for Lessees • Legal approach • Material equity • Transfer of the benefits and risks of ownership
Lease Accounting Standards • ARB 38 • APB Opinion No. 5 • APB Opinion No. 10 • APB Opinion No. 31 • SFAS No. 13 (as Amended Through SFAS No. 98)
Lease Accounting Standards • APB Opinion No. 7 • issued in 1966 • first standard to address lessor accounting • APB Opinion No. 27 • SFAS No. 13 • lessee and lessor accounting achieved near symmetry
Sale and Leaseback • Occurs when the owner of an asset legally sells it and enters into a lease agreement to lease the asset back • Lessor (new legal owner) and lessee (original legal owner) both use the standard criteria for classifying such a lease as operating or capital
Leveraged Leases • From a lessee’s viewpoint, a leveraged lease is not any different from other leases • From lessor’s viewpoint...possibly • is the same as a conventional financing-type lease with an additional debt transaction between the lessor and the third party • is to regard a leveraged lease as a unique type of lease warranting special rules applicable to its special circumstances
SFAS No. 13 • Survey and capital market research supports the position that the reporting of capital leases is useful and relevant. • However, a strong case can be made for capitalizing all leases extending beyond one year. This type of rigid uniformity would eliminate the attempts to circumvent SFAS No. 13
Economic Consequences • costs of complying with lease capitalization • more critical concern has been whether lease capitalization might provide disincentives for leasing itself
G4+1 proposal on leases • G4+1 the major standard-setting bodies from • Australian Accounting Standards Board • Canadian Accounting Standards Board • New Zealand Financial Reporting Standards Board • United Kingdom Accounting Standards Board • United States Financial Accounting Standards Board • The International Accounting Standards Committee participates in the work of the G4+1 as an observer
G4 + 1 Report • It would eliminate the distinction between operating and financing leases by making all leases financing leases. • It would move leases from the area of finite uniformity to rigid uniformity. • In addition, for the lessee it would result in showing operating leases as assets which would certainly be the case since they embody the definition of assets from the conceptual framework.
IFRS • Lease accounting under the IASB • Differs in that the FASB has a rules based orientation with “bright lines” carefully laid out (the 75% rule). IAS 13 requires more judgment than SFAS No. 13. • Is similar in that manipulation can occur under either standard. • December 2006, the IASB and FASB announced formation of the International Working Group on Lease Accounting to converge the standards.
Improving Accounting Standards • In line with the G4+1 Report, eliminate the distinction between operating and capital leases. • All leases should become capital leases.
Summary • Lease accounting represents a classic example of the search for meaningful finite uniformity. • Emphasis is on economic substance rather than legal form. • A strong case can be made for capitalizing all leases extending beyond one year. • This type of rigid uniformity would eliminate the attempts to circumvent SFAS No. 13. • This is exactly what the G4+1 special report advocated.
LEASE 29 May 2007 Lecture Recap • The lease contract • Evolution of lease accounting standards • Economic consequences of lease capitalization. • G4+1 proposal on leases • IFRS