Accounting for Capital Leases

Accounting for Capital Leases

A capital lease is treated for accounting purposes as if the leased asset were purchased and financed over time. The question then arises as to how the value of the leased asset and the corresponding liability should

be recorded on the lessee’s balance sheet at the inception of the lease. FAS 13 requires that these amounts be recorded at the inception of the lease as the lower of (1) the present value of the minimum lease pay- ments during the lease term or (2) the fair market value of the leased asset. 3

Once the asset and liability at the inception of the lease have been determined, the depreciation charge and the interest expense associated with the liability must be determined. Although the amounts of the asset and liability are the same at the inception of the lease, the subsequent depreciation and interest expense are computed independently.

3 The minimum lease payments are defined as the sum of (i) the minimum lease pay- ments required during the lease term and (ii) the amount of any bargain purchase op-

tion. In the absence of a bargain purchase option, the amount of any guarantee of the residual value and the amount specified for failure to extend or renew the lease are used in lieu of (ii). Excluded from the minimum lease payments are executory costs where these are required to be paid by the lessee to the lessor.

SELECTED TOPICS IN FINANCIAL MANAGEMENT

EXHIBIT 27.1 Lease Commitments Footnote Disclosure in Fiscal 1999 Annual

Report of Circuit City Stores, Inc.

In addition, the following footnote disclosures for capital leases are required in the lessee’s financial statement:

1. The gross amount of assets recorded under capital leases presented by major classes according to nature or function. The lessee can combine this information for owned assets, which the company must also dis- close.

2. Future minimum lease payments in the aggregate and for each of the five succeeding years (deducting executory costs) and the amount of imputed interest in reducing the minimum lease payments to present value.

Equipment Leasing

3. Total contingent lease payments actually incurred for each period for which an income statement is presented.

4. A general description of the leasing arrangement, which would include restrictions imposed by the lease arrangement, the existence of renewal or purchase options, and escalation clauses.

Exhibit 27.1 illustrates the footnote disclosure for capital lease commit- ments.

The impact of the accounting treatment of leases on reported income is usually minimal. The primary concern of management is, therefore, not with the impact on reported income but with the effect on the firm’s debt-to-equity ratio. As explained in Chapter 22, this ratio is commonly employed by creditors and investors to determine whether a company is overburdened with debt. With a capital lease, the debt-to- equity ratio will be greater than if the lease is treated as an operating lease because of the lease obligation reported in the balance sheet. How- ever, it is naive to assume that market participants are untutored about the impact of noncapitalized leases on the debt-equity ratio. Certainly rating agencies take into account leasing arrangements in assigning a credit rating.