CHAPTER 15 Leases 855 Whether or not there is any real effect on security prices, sometimes off-balance-sheet financing helps a firm avoid exceeding contractual limits on designated financial ratios (like the debt to equity ratio, for instance). 2 When the operational, tax, and financial market advantages are considered, the net cost of leasing often is less than the cost of purchasing. ● Operational, tax, and financial market incentives often make leasing an attractive alternative to purchasing. Capital Leases and Installment Notes Compared You learned in the previous chapter how to account for an installment note. To a great extent, then, you already have learned how to account for a capital lease. To illustrate, let’s recall the situation described in the previous chapter. We assumed that Skill Graphics purchased a package-labeling machine from Hughes–Barker Corporation by issuing a threeyear installment note that required six semiannual installment payments of $139,857 each. That arrangement provided for the purchase of the $666,633 machine as well as interest at an annual rate of 14% (7% twice each year). Remember, too, that each installment payment consisted of part interest (7% times the outstanding balance) and part payment for the machine (the remainder of each payment). Now let’s suppose that Skill Graphics instead acquired the package-labeling machine from Hughes–Barker Corporation under a three-year lease that required six semiannual rental payments of $139,857 each. Obviously, the fundamental nature of the transaction remains the same regardless of whether it is negotiated as an installment purchase or as a lease. So, it would be inconsistent to account for this lease in a fundamentally different way than for an installment purchase: 2 It is common for debt agreements, particularly long-term ones, to include restrictions on the debtor as a way to provide some degree of protection to the creditor. Sometimes a minimum level is specified for current assets relative to current liabilities, net assets, debt as a ratio of equity, or many other financial ratios. Often a restriction is placed on dividend payments, share repurchases, or other activities that might impede the debtor’s ability to repay the debt. Typically, the debt becomes due on demand when the debtor becomes in violation of such a debt covenant, often after a specified grace period. ● LO15–2 In keeping with the basic accounting concept of substance over form, accounting for a capital lease parallels that for an installment purchase. At Inception (January 1) Installment Note Machinery ...................................................................................... 666,633 Note payable ............................................................................ 666,633 Capital Lease Leased machinery .......................................................................... 666,633 Lease payable ........................................................................... 666,633 Comparison of a Note and Capital Lease Each payment includes both an amount that represents interest and an amount that represents a reduction of principal. At the First Semiannual Payme nt Date (June 30) Installment Note Interest expense (7% 3 $666,633) ................................................ 46,664 Note payable (difference) .............................................................. 93,193 Cash (installment payment) ........................................................ 139,857 Capital Lease Interest expense (7% 3 $666,633) ................................................ 46,664 Lease payable (difference) ............................................................. 93,193 Cash (rental payment) ................................................................ 139,857 Interest Compared for a Note and Capital Lease Consistent with the nature of the transaction, interest expense accrues each period at the effective rate times the outstanding balance: Because the lease payable balance declines with each payment, the amount of interest expense decreases each period. An amortization schedule is convenient to track the changing amounts as shown in Illustration 15–2 .
Spiceland_Inter_Accounting8e_Ch15
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