Abstract
This chapter explores a company’s decision to enter into a lease contract to finance capital investments. We discuss the motivations behind the lease-versus-buy tradeoff in terms of both the economics of and accounting for lease financing arrangements. Throughout our discussion, we reference academic research related to the lease-versus-buy decision, the factors influencing the extent of leasing activity, the economic consequences of lease financing, and the role of lease-related accounting standards. We also provide a detailed review of the provisions in the current lease accounting standards that were recently issued by the Financial Accounting Standards Board and the International Accounting Standards Board.
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Notes
- 1.
Naturally, the lessor will be concerned about the condition of the leased asset at the end of the lease term. As such the lessor may monitor the lessee and include in the lease agreement certain clauses about the minimum residual value of the asset at the end of the lease.
- 2.
The tax and bankruptcy laws in the U.S. and many other countries maintain relatively similar criteria for classifying a lease as either a “true lease” (basically a rental agreement) or a financed purchase (Eisfeldt and Rampini 2009, p. 1626). This is important because the same general criteria that allowed a company to report a lease off-balance-sheet for financial reporting purposes also resulted in tax benefits and bankruptcy protections that make it difficult to determine whether a company was structuring a lease for a desired financial reporting outcome or for the benefits associated with tax consequences or expanded borrowing capacity.
- 3.
FASB Statement No. 13, which is now superseded, was codified as Topic 840, Leases. Note that prior to Statement No. 13, leases were only disclosed in the notes to the financial statements.
- 4.
FASB Statement No. 13 required lessees to disclose certain information about operating lease commitments, including the minimum lease payments due in the current fiscal year, the subsequent five fiscal years, and a lump sum amount reflecting the fiscal years thereafter.
- 5.
We refer readers to Spencer and Webb (2015) for a review of the literature related to lease accounting from the perspective of lessees.
- 6.
The SEC, for instance, indicated in its report that it estimated there was outstanding a total of $1.25 trillion in off-balance-sheet operating lease obligations.
- 7.
For simplicity, we refer to a lease as if it applies to only a single leased asset. In practice, additional complexities can arise. For example, an arrangement could include several lease components as well as nonlease components. ASC 842 requires that a company allocate the contract consideration to each separate component of the contract. Each lease component would have to be classified and accounted for separately. Nonlease components (e.g., for the provision of services, such as maintenance) would also need to be accounted for separately following the appropriate accounting guidance.
- 8.
The previous lease accounting rules required that a lessee classify a lease at the inception date (e.g., the date the lease is signed). ASC 842 requires that a lessee determine whether a lease exists at the inception date, while the classification determination is made at the commencement date. The commencement date is the date on which a lessor makes an underlying leased asset available to the lessee.
- 9.
As noted in the section addressing lessor accounting, all else equal, the lessor would classify the lease as a sales-type lease, reflecting the de facto sale of the asset from the perspective of conferring control of the underlying leased asset to the lessee.
- 10.
It is important to recognize that lease classification and lease measurement (e.g., the measurement of the lease liability) are not necessarily the same. For example, the lease payments classification criterion requires a lessee and lessor to consider the present value of the sum of the lease payments and any residual value guaranteed by the lessee. In contrast, for purposes of measuring the lease liability, only lessee residual value guarantees that are probable of being paid are considered. In addition, the lease liability reflects the present value of the remaining lease payments, while the lease payments classification criterion considers all payments, including payments made before the commencement date.
- 11.
The lessor will defer initial direct costs if, at the lease commencement date, the fair value of the underlying leased asset is equal to its carrying value. In such a case, the deferred initial direct costs would be included in the determination of the rate implicit in the lease.
- 12.
- 13.
As discussed previously, the calculation of lease payments for the lease payments test included in the classification criteria does not necessarily reflect the lease payments included in the lease liability at the commencement date. The lease payments test includes all payments, including payments made prior to the commencement date and a lessee’s residual value guarantee, regardless of whether it is probable that the lessee will owe amounts associated with the guarantee (if any).
- 14.
Note, for example, that if the lease contains a purchase option that the lessee is reasonably certain to exercise, the right-of-use asset would be amortized over the useful life of the asset rather than the lease term.
- 15.
A selling loss at the commencement date would be recognized immediately.
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Lee, CF., McDonough, R. (2021). The Economics of and Accounting for Lease Transactions. In: Lee, CF., Lee, A.C. (eds) Encyclopedia of Finance. Springer, Cham. https://doi.org/10.1007/978-3-030-73443-5_88-1
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