Many of the inquiries I receive here at Leasing Notes relate to the topic of off balance sheet financing, so I thought that a series of discourses on the subject might be in order. As you know, leasing is a technique that many companies use to improve their financial statement presentation. An operating lease, for instance, is not recorded on the lessee's balance sheet -- it is off balance sheet. In these upcoming posts, I will discuss and illustrate how the characteristics of a lease determine its classification for accounting purposes, how the accounting (financial reporting) classification affects the way lessees report the expense, and the impact of off balance sheet reporting. So, let’s get started.
Leases are classified as either operating leases or capital leases for financial reporting purposes. An operating lease is a true usage agreement, not a financing. The lessor is the accounting owner of the equipment and allows the lessee to use it for a fee. A capital lease, on the other hand, is a form of financing. The lessee is the accounting owner of the equipment in a capital lease and the lessor finances it over time. These accounting guidelines do not impact cash, only the balance sheet presentation of the lease and the timing of its expenses and income.
The Financial Accounting Standards Board (FASB) sets the criteria for classifying leases and the rules for reporting them in the financial statements. FASB Statement No. 13, Accounting for Leases (FASB 13), contains the accounting rules for lease transactions. These rules are based on the substance of the transaction, not its form. (The lease accounting rules in the European Union (IAS 17), the UK, Australia, and much of Asia follow the same concepts.)
A lease that transfers substantially all the benefits and risks of ownership to the lessee, for example, resembles a purchase by the lessee. The lessee should account for it, therefore, as the acquisition of an asset with 100% debt. If the lease does not transfer substantially all the benefits and risks of ownership to the lessee, then it is an operating lease. The differences in classification are shown below.
Capital Lease
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Balance Sheet
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Income Statement
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Leased asset
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(Depreciation expense)
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Lease obligation
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(Interest expense)
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Operating Lease
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Balance Sheet
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Income Statement
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-0-
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(Rent expense)
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FASB 13 establishes the criteria for classifying leases as either capital or operating. The goal of these criteria is to establish who, in substance, owns the equipment. The lessee and the lessor apply the FASB 13 criteria independently of each other. The result of this independent classification is that each party may classify the same lease differently. This is alright because the accounting classification does not impact cash flow. The lessor and lessee make their classification decisions at the inception of the lease. This classification, once made, cannot be changed at a later date.
Four classification criterion are used to determine whether a lease more closely resembles a purchase agreement (capital lease) or an usage agreement (operating lease). If a transaction meets any one of the four criteria, it is classified as capital. If it does not meet any of the four criteria, it is classified, by default, as an operating lease. Each criterion indicates some form of ownership by the lessee. These criteria are:
1. The lease automatically transfers ownership of the property to the lessee by the end of the lease term.
2. The lease contains a bargain purchase option.
3. The lease term is equal to or greater than 75% of the estimated economic life of the leased property.
4. The present value of the minimum lease payments is equal to or greater than 90% of the FMV of the leased property.
I will get into the detail of these criteria mean in subsequent posts.
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