leases leases classifications leases disclosure

2. Presented To: Ma’am
Munaza
PRESENTED BY: SALSABEEL
ZAHRA
ROLL NO: F65
BBA 8TH (FINANCE)
ISLAMIA UNIVERSITY
BAHAWALPUR

3. Contents
 Leases
 Accounting and reporting for lease
 Lease disclosure
 Analyzing lease

4. Lease and Leasing
 Lease is a contractual agreement between owner and user.
 Leasing is a process by which a firm can obtain the use of certain
fixed assets for which it must pay a series of contractual,
periodic, tax deductible payments.
 In this contractual agreement we used two terms lessee and the
lessor
 Lessee is a user and the lessor is owner

5. Leasing: Types of Leases
 We are going to discuss two types of lease
• Operating lease
• Capital lease

6. Types of Leasing
 Operating Lease
Operating lease is an agreement that gives the right to use assets but does
not provide the right of ownership of an asset.
Operating leases are used for short-term leasing of assets and are similar to
renting.
 Capital Lease
Capital lease is a lease agreement in which the lessor agrees to transfer the ownership
rights to the lessee after the completion of the lease period.
Capital lease is a long-term rather than operating lease.
Capital lease involves the transfer of ownership rights of the asset to the
lessee.

7. Accounting And Reporting For Lease
(Lease Classification and Reporting)
 A lessee (the party leasing the asset) classifies and accounts for a lease as a
capital lease the lease meets any of four criteria:
 The lease transfers ownership of the property to the lessee by the end of the
lease term
 The lease contains an option to purchase the property at a bargain price
 The lease term is 75% or more of the estimated economic life of the property
 The present value of the minimum lease payments (MLPs) at the beginning
of the lease term is 90% or more of the fair value of the leased property
 A lease can be classified as an operating lease only when none of these
criteria are met

8. Accounting And Reporting For Lease
(Lease Classification and Reporting)
 The lessee records it (both asset and liability) at an amount equal to the
present value of the minimum lease payments over the lease term
(excluding executory costs such as insurance, maintenance, and tax paid by
the lessor that are included in the MLP)
 The accounting rules require that all lessees disclose, usually in notes
financial statements:
 Future minimum lease payments separately for capital leases and
operating leases for each of the five succeeding years and the total
amount
 Rental expense for each period that an income statement is reported.

9. Accounting And Reporting For Lease
(Accounting for Leases)
 This section compares the effects of accounting for a lease as either a capital
or an operating lease
 Specifically, we look at the effects on both the income statement and the
balance sheet of the lessee given the following information:
o A company leases an asset on January 1, 2005—it has no other assets or
liabilities.
o Estimated economic life of the leased asset is five years with an expected
salvage value of zero at the end of five years. The company will depreciate
this asset on a straight-line basis over its economic life.
o The lease has a fixed noncancellable term of five years with annual minimum
lease payments of $2,505 paid at the end of each year.
o Interest rate on the lease is 8% per year.

10. Accounting And Reporting For Lease
(Accounting for Leases)
Lease amortization schedule (continued)
Straight line depreciation (10000-0/5 years)
Interest and principal component of MLP
Year Beginning year
liabilty
Interest Principal Total Year end liability
2005 $ 10000 800 1705 2505 8295
2006 $ 8295 664
1,841
2,505 6,454
2007 $ 6454 517 1,988 2,505 4,466
2008 $ 4466 358 2,147 2,505 2,319
2009 $ 2319 186 2,319 2,505 0
Total 2,525 $10,000 $12,525

11. Accounting And Reporting For Lease
(Accounting for Leases)
Income Statement Effects of Alternative Lease Accounting Methods
Operating lease Capital lease
Year Rent Exp Interest Exp Depreciation Exp Total Exp
2005 2,505 800 2,000 2,800
2006 2,505 664 2,000 2,664
2007 2505 517 2,000 2,517
2008 2,505 358 2,000 2,358
2009 2,505 186 2,000 2,186
Total 12,525 $2,525 $10,000 $12,525

12. Accounting And Reporting For Lease
(Accounting for Leases)
Balance Sheet Effects of Capitalized Leases
Monthly/Day/Year Cash Leased Asset Lease Liability Equity
1/1/2005 $ 0 $10,000 $10,000 $ 0
12/31/2005 (2,505) 8,000 8,295 (2,800)
12/31/2006 (5,010) 6,000 6,454 (5,464)
12/31/2007 (7,515) 4,000 4,466 (7,981)
12/31/2008 (10,020) 2,000 2,319 (10,339)
12/31/2009 (12,525) 0 0 (12,525)

13. Lease Disclosure
 A lessor must disclose qualitative and quantitative information about its leasing
activities including the nature of the lessor's leasing activities
 The lessor manages risks associated with any retained rights in assets, a maturity
analysis of lease payments receivable and a reconciliation of the discounted lease
 These disclosures are useful for analysis purposes.
 Lease Disclosure and Off-Balance-Sheet Financing Lease Disclosure Lessee must
disclose:
 Future MLPs separately for capital leases and operating leases for each of five
succeeding years and the total amount
 Rental expense for each period an income statement is reported Off-Balance-Sheet
Financing
 Off-Balance-Sheet financing is when a lessee structures a lease so it is accounted for as
an operating lease when the economic characteristics of the lease are more in line with a
capital lease neither the leased asset nor its corresponding liability are recorded on the
balance sheet

14. Analyzing Lease
 This section looks at the impact of operating versus capital leases for financial statement
analysis
 It gives specific guidance on how to adjust the financial statements for operating leases
that should be accounted for as capital leases.
 Before embarking on a discussion of how to convert operating leases to capital
 leases, it is important to note that the FASB and IASB are close to issuing a joint
 standard that eliminates operating lease treatment.
 A draft version of this standard is expected to be ready soon, and a final version of the
standard should be completed within a year or two.
 Once this standard becomes effective, under both US GAAP and IFRS, all leases will need
to be accounted for as capital leases.
 This standard will eliminate one of the most important forms of off-balance-sheet
financing.

15. Impact of Operating Leases
 Operating lease understates liabilities improves solvency ratios such as
debt to equity
 Operating lease understates assets can improve return on investment
ratios
 Operating lease delays expense recognition overstates income in early
term of the lease and understates income later in lease term
 Operating lease understates current liabilities by ignoring current portion
of lease principal payment inflates current ratio & other liquidity measures
 Operating lease includes interest with lease rental (an operating expense)
understates both operating income and interest expense, inflates interest
coverage ratios, understates operating cash flow, & overstates financing
cash flow

16. Converting Operating Leases to Capital Leases
 An operating lease is different from a capital lease and must be treated differently for accounting
purposes. Under an operating lease, the lessee enjoys no risk of ownership, but cannot deduct
depreciation for tax purposes.
 For a lease to qualify as a capital lease, it must meet any of the following criteria as outlined by GAAP
 The lease term is greater than or equal to 75% of the asset’s estimated useful life
 The present value of the lease payments is greater than or equal to 90% of the fair value of the asset
 Ownership of the asset may be transferred to the lessee at the end of the lease
 The lease contains a bargain purchase option for the lessee to buy the equipment below market value at
the end of the lease
 Additionally, under IFRS, there are a few more criteria that a lease can meet to qualify as a capital
lease:
 The leased assets are specialized to the point that only the lessee can utilize these assets without major
changes being made to them
 Under a capital lease, the lessee is considered an owner and can claim depreciation and interest
expense for tax purposes. The leased asset and lease obligation are shown on the balance sheet.