What factors enter into choosing the accounting method for leases under U.S. GAAP and IFRS?

Answer 1

CHOOSING THE ACCOUNTING METHOD FOR LEASES

The capital lease method results in larger long-term debt and debt-equity ratios during the life of a lease than the operating lease method. A larger debt ratio makes a firm appear more risky. Thus, given a choice, lessees tend to prefer the operating lease method to the capital lease method. The operating lease method also recognizes expense more slowly over the life of the lease than the capital lease method. These financial statement effects often lead lessees to structure leases so that they take the form of an operating lease.

Standard-setting bodies have tried to specify rules precluding the use of the operating lease method when leases transfer the rewards and risks of ownership from the lessor to the lessee.

U.S. GAAP Criteria for Lease Accounting

U.S. GAAP specifies criteria for a capital lease. If a particular lease meets any one of the following four conditions, the lessor and lessee account for the lease as a capital lease. If the lease meets none of the four conditions, firms treat the lease as an operating lease.

1 . The lease transfers ownership of the leased asset to the lessee at the end of the lease term.

2 . Transfer of ownership at the end of the lease term seems likely because the lessee has a bargain purchase option. A bargain purchase option gives the lessee the right to purchase the leased asset at a specified future time for a price less than the currently predicted fair value of the property at that future time.

3 . The lease extends for at least 75% of the asset's expected useful life.

4 . The present value of the contractual minimum lease payments equals or exceeds 90% of the fair value of the asset at the time the lessee signs the lease. The present value computation uses a discount rate appropriate for the creditworthiness of the lessee.

These criteria attempt to identify who enjoys the benefits and bears the economic risks of the leased property. If the leased asset, either automatically or for a bargain price, becomes the property of the lessee at the end of the lease period, then the lessee enjoys all of the economic benefits of the asset and incurs all risks of ownership. If the life of the lease extends for most of the expected useful life of the asset (U.S. GAAP specifies 75% or more), then the lessee enjoys most of the benefits, particularly when we measure them in present values, and incurs most of the risk of technological obsolescence.

Lessors and lessees can usually structure leasing contracts to avoid the first three conditions. Avoiding the fourth condition is more difficult because it requires the lessor to bear more risk than it might desire. The fourth condition compares the present value of the lessee's contractual minimum lease payments with the fair value of the leased asset at the time the lessee signs the lease. The lessor presumably could either sell the asset for its fair value or lease it to the lessee for a set of lease payments. The present value of the minimum lease payments has the economic character of a loan in that the lessee has committed to make payments just as it would commit to make payments on a loan with a bank. When the present value of the contractual minimum lease payments equals at least 90% of the amount that the lessor would receive if it sold the asset instead of leasing it, then the lessor receives most of its return from the leasing arrangement. That is, 90% of the fair value of the asset is not at risk, and the lessor need receive only 10% of the fair value of the asset at the inception of the lease from selling or releasing the asset at the end of the lease term.

Under these conditions, the fourth criterion views the lessee as enjoying most of the rewards and bearing most of the risk of ownership, and the lease therefore qualifies as a capital lease. If, on the other hand, the lessor has more than 10% of the asset's initial fair value at risk, then the criterion views the lessor as enjoying most of the benefits and bearing most of the risks of ownership and would classify the lease as an operating lease. This fourth criterion has presented the most difficulties in practice because small changes in the amount or timing of lease payments can shift the present value of the lease payments to just below or just above the 90% threshold.

IFRS Criteria for Lease Accounting

IFRS uses the same general criterion for classifying leases: Which party to the lease enjoys the rewards and bears the risk in a leasing arrangement? Unlike U.S. GAAP, IFRS does not specify strict percentages, such as the 75% useful life criterion or the 90% present value criterion. Instead, IFRS identifies several indicators about which entity enjoys the rewards and bears the risk in the leasing arrangement and permits firms and their independent accountants to apply their professional judgment to classify a lease as an operating lease versus a capital lease. The criteria are similar to those of U.S. GAAP but not as specific:

1 . Does ownership transfer from the lessor to the lessee at the end of the lease?

2 . Is there a bargain purchase option?

3 . Does the lease extend for the major part of the asset's economic life?

4 . Does the present value of the minimum lease payments equal substantially all of the asset's fair value?

5 . Is the leased asset specialized for use by the lessee?

A lease for which the present value of the minimum lease payments was 89.9% of the fair value of the leased asset at inception of the lease could escape capital lease treatment under
U.S. GAAP but might not under IFRS.