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This GAAP Review Series is designed for the accountant or practitioner who needs a detailed review of standards that apply to nonspecialized companies. The series provides a comprehensive study of FASB Statements and Interpretations and APB Opinions that apply to all companies and presents implementation guidelines and disclosure illustrations.
GAAP Review Series — Part 2
Objectives:
Also available in the GAAP Review Series:
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Chapter 1
Accounting for Leases
Learning Objectives
After completing this chapter you will be able to
Introduction
This chapter emphasizes accounting by lessees: however, there are many parallels between lessee and lessor accounting. Where appropriate, the modules are organized into A and B parts that describe the lessee's accounting and the lessor's accounting, respectively. In all of the twopart modules, the description of the lessor's accounting in part B is abbreviated and relies on the more complete description of the lessee's accounting presented in part A.
A lease contract gives the lessee (leaseholder) certain rights related to the leased property and imposes an obligation to pay for these rights. The rights of the lessee are less than those obtained from the purchase of the property. Generally accepted accounting principles establish criteria for determining whether a lease agreement transfers sufficient rights to give the transaction the substance of an outright purchase. If the accounting criteria are met, the lease is described as a capital lease, and the leased asset and the lease obligation are reported in the lessee's balance sheet. If effect, the lease is reported in the same manner as an installment purchase of the leased asset. If the accounting criteria are not met, the lease is described as an operating lease and is reported as an executory contract in the periods that performance occurs.
The flexibility that lease agreements provide with respect to property rights and financial obligations results in continued growth in the volume of lease transactions. Consider the following:
In addition, many companies prefer the off-balance-sheet financing aspect of operating leases. To the extent that a company's balance sheet appears to have too much debt or it is close to defaulting on existing debt covenants, operating leases may provide a financing mechanism that does not cause further deterioration in critical debt-equity ratios. Although one may question the real benefits of off-balance-sheet financing, many lessees carefully structure lease agreements to avoid meeting the accounting requirements for capital lease treatment. In fact, the strong desire of companies to maintain the ability to obtain the off-balance-sheet treatment has influenced both the Accounting Principles Board and the Financial Accounting Board to issue accounting standards that are lenient with respect to requiring capital lease accounting.
Accounting for lease agreements often is complicated by differences between their legal form and their economic substance. If sufficient property rights are transferred, the economic substance of a lease is the same as a legal purchase. But how is the determination made that a lease agreement transfers sufficient property rights to the lessee to justify reporting the lease as if a purchase has occurred? GAAP provides specific criteria to identify the critical point at which a lease must be reported as a capital lease. Nonetheless, GAAP does not assure that companies with substantially identical lease agreements will report these lease agreements identically. In fact, the criteria are such that companies wishing to avoid capital lease accounting while obtaining most of the benefits of ownership generally are able to do so.
SFAS No. 13, Accounting for Leases, supersedes all prior lease accounting pronouncements and prescribes both the primary criteria for classifying lease agreements and the basic accounting methods. Since it was issued in 1976, SFAS No. 13 has been amended by SFAS Nos. 22, 23, 27, 28, 29, 76, 77, 91, 94, 96, 98, SFAS Interpretation Nos. 19, 21, 23, 24, 26, 27, and several FASB Technical Bulletins. In spite to this large volume of pronouncements, the FASB has not made substantive changes in lease accounting. The recent changes in SFAS No. 13 generally represent fine tuning or guidance for new types of lease transactions. The continuing innovation in the structure of lease agreements makes lease accounting one of the most complex topics accountants face today.
Because of the many changes that have occurred in accounting for leases, the FASB has issued two comprehensive publications that included all authoritative pronouncements related to lease accounting. The first was published in 1980 and the second, Accounting for Leases: FASB Statement No. 13 as amended and interpreted (incorporating FASB Statements, Interpretations, and Technical Bulletins issued through January 1990), in 1990. The latter document corresponds to the June 1, 1995, editions of the FASB Current Text with the exception of minor changes resulting from the issuance of SFAS No. 109.
Wherever possible, the references in this chapter are to the paragraph numbers of Accounting for Leases: FASB Statement No. 13 as amended and interpreted…, which are the same as those in the Current Text. Paragraph numbers 100-499 are authoritative and are based on either FASB Statements or their Interpretations. Paragraphs numbered 500-599 are based on FASB Technical Bulletins.
Currently, the FASB and the IASB are continuing work on a joint project on leases. The objective of the accounting for leases project is to comprehensively reconsider the guidance in SFAS No. 13 and IAS 17, Leases, along with subsequent amendments and interpretations, to ensure that financial statements provide useful, transparent, and complete information about leasing transactions to investors and other users of financial statements. The Boards began deliberations of lease accounting issues in 2007. They expect to publish a Discussion Paper for public comment in 2009 that will explore those issues and describe both Boards' preliminary views.
Applicability of the FASB Pronouncements
SFAS No. 13 and the subsequent pronouncements that are discussed in this chapter apply to financial reporting of leases by both lessors and lessees.
A lease is an agreement that conveys the right to use property, plant, or equipment usually for a stated period of time (paragraph .101).1 Significantly, this definition does not include agreements that convey the right to use only intangible assets or services. However, agreements that include substantial services or intangibles in addition to plant, property, or equipment are considered leases for the purposes of financial reporting.
The standards do not apply to (paragraph .101):
1 All paragraph references are for the FASB's comprehensive publication, Accounting for Leases: FASB Statement No. 13 as amended and interpreted (incorporating FASB Statements, Interpretations, and Technical Bulletins issued through January 1990), and correspond to the paragraph numbers in the lease chapter (10) of the Current Text as of June 1, 1993.
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