Capital Leases

A previous chapter introduced the idea of a "capital lease." Such transactions enable the lessee to acquire needed productive assets, not by outright purchase, but by leasing. The economic substance of capital leases, in sharp contrast to their legal form, is such that the lessee effectively assumes the risks and rewards of owning the asset. Further, the accompanying obligation for lease payments is akin to a note payable. That is, the lessee is under contract to make a stream of payments over time that substantively resembles the stream of payments that would have occurred had the lessee purchased the asset via a promissory note. Accounting rules attempt to track economic substance ahead of legal form. Thus, when an asset is acquired via a capital lease, the initial recording is to establish both the asset and related obligation on the lessee's balance sheet.

Assume that equipment with a five-year life is leased on January 1, 20X1, and the lease agreement provides for 5 end-of-year lease payments of $23,739.64 each. At the time the lease was initiated, the lessee's incremental borrowing rate (the interest rate the lessee would have incurred on similar debt financing) is assumed to be 6%. The accountant would discount the stream of payments using the 6% interest rate and find that the present value of the fixed non cancelable lease payments is $100,000. Therefore, the following entry would be necessary to record the lease:

After the initial recording, the accounting for the asset and obligation take separate paths. The asset is typically depreciated over the lease term (or useful life, depending on a variety of conditions). The depreciation method might be straight-line or an accelerated approach. Essentially, the leased asset is accounted for like any other owned asset of the company. The Obligation Under Capital Lease is accounted for like a note payable. In the above example, the amounts happen to correspond to the amounts illustrated for the mortgage note introduced earlier in the chapter. Therefore, the first lease payment would be accounted for as follows:

Notice that this entry results in recording interest expense - not rent. This scheme would be applied for each successive payment, until the final payment extinguishes the Obligation Under Capital Lease account. The accounting outcome is virtually identical (i.e., changing amounts of interest expense as the obligation is reduced over time) to that associated with the mortgage note illustrated earlier in the chapter.

The Fair Value Measurement Option

The Financial Accounting Standards Board recently issued a profound standard, "The Fair Value Option for Financial Assets and Financial Liabilities." The title is quite revealing. Companies are now permitted, but not required, to measure certain financial liabilities at fair value. Changes in fair value can result from many factors, including market conditions pertaining to the overall interest rate environment. Entities that opt for this standard are to report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. This new standard is a profound shift in methodology, and has the potential to eventually reshape debt accounting. Because the new standard is "optional" and somewhat "controversial," it is very difficult to predict its practical effect and eventual implications. However, it is indicative of a clear intent to embrace more fair value methodology into the overall accounting framework.