856 SECTION 3 Financial Instruments and Liabilities You should recognize this as essentially the same amortization schedule we used in the previous chapter in connection with our installment note example. The reason for the similarity is that we view a capital lease as being, in substance, equivalent to an installment purchase. So naturally the accounting treatment of the two essentially identical transactions should be consistent. Lease Classification A lease is accounted for as either a rental agreement or a purchase/sale accompanied by debt financing. The choice of accounting method hinges on the nature of the leasing arrangement. Capital leases are agreements that we identify as being formulated outwardly as leases, but which are in reality essentially installment purchases. Sometimes the true nature of an arrangement is obvious. For example, a 10-year noncancelable lease of a computer with a 10-year useful life, by which title passes to the lessee at the end of the lease term, obviously more nearly represents a purchase than a rental agreement. But what if the terms of the contract do not transfer title, and the lease term is for only seven years of the asset’s 10-year life? Suppose contractual terms permit the lessee to obtain title under certain prearranged conditions? What if compensation provided by the lease contract is nearly equal to the value of the asset under lease? These situations are less clear-cut. Professional judgment is needed to differentiate between leases that represent rental agreements and those that in essence are installment purchases/sales. It’s important to note that from an accounting perspective legal ownership is irrelevant in the decision. The essential question is whether the usual risks and rewards of ownership have been transferred to the lessee. But judgment alone is likely to lead to inconsistencies in practice. The desire to encourage consistency in practice motivated the FASB to provide guidance for distinguishing between two fundamental types of leases: capital leases and operating leases. 3 As you study the classification criteria in the following paragraphs, keep in mind that some leases clearly fit the classifications we give them, but others fall in a gray area somewhere between the two extremes. For those, we end up forcing them into one category or the other by somewhat arbitrary criteria. Classification Criteria A lessee should classify a lease transaction as a capital lease if it includes a noncancelable lease term and one or more of the four criteria listed in Illustration 15–3 are met. 4 Otherwise, it is an operating lease. A basic concept of accounting is substance over form. Accounting for leases attempts to see through the legal form of the agreements to determine their economic substance. 3 FASB ASC 840–10–15: Leases–Overall–Recognition (previously “Accounting for Leases,” Statement of Financial Accounting Standards No. 13 (Stamford, Conn.: FASB, 1980), par. 7). ● LO15–3 4 Noncancelable in this context does not preclude the agreement from specifying that the lease is cancelable after a designated noncancelable lease term. Unless some portion of the lease term is noncancelable, it is an operating lease. Later in this section, we discuss treatment of any cancelable portion of the lease term. Illustration 15–2 Lease Amortization Schedule Date Payments Effective Interest Decrease in Balance Outstanding Balance (7% 3 Outstanding balance) 666,633 1 139,857 .07(666,633) 5 46,664 93,193 573,440 2 139,857 .07(573,440) 5 40,141 99,716 473,724 3 139,857 .07(473,724) 5 33,161 106,696 367,028 4 139,857 .07(367,028) 5 25,692 114,165 252,863 5 139,857 .07(252,863) 5 17,700 122,157 130,706 6 139,857 .07(130,706) 5 9,151* 130,706 0 839,142 172,509 666,633 *Rounded Each rental payment includes interest on the outstanding balance at the effective rate. The remainder of each payment reduces the outstanding balance.
Spiceland_Inter_Accounting8e_Ch15
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