Question 15-1

Regardless of the legal form of the agreement, a lease is accounted for as either a rental agreement or a purchase/sale accompanied by debt financing depending on the substance of the leasing arrangement. Capital leases are agreements that are formulated outwardly as leases, but that are in reality installment purchases. Professional judgment is needed to differentiate between leases that represent “rental agreements” and those that in reality are “installment purchases/sales.” The FASB provides guidance for distinguishing between the two fundamental types of leases.

Question 15-2

Periodic interest expense is calculated by the lessee as the effective interest rate times the amount of the outstanding lease liability during the period. This same principle applies to the flip side of the transaction, i.e., the lessor’s lease receivable (net investment). The approach is the same regardless of the specific form of the debt – that is, whether in the form of notes, bonds, leases, pensions, or other debt instruments.

Question 15-3

Leases and installment notes are very similar. The fundamental nature of the transaction remains the same regardless of whether it is negotiated as an installment purchase or as a lease. In return for providing financing, the borrower (lessee) paysinterestover the maturity (lease term). Conceptually, leases and installment notes are accounted for in precisely the same way.

Question 15-4

Current GAAP does allow airlines' balance sheets to appear as if the companies don't have airplanes.That’s because most airlines extensively use operating leases to “acquire” airplanes. Under current rules, under operating leases, unlike capital leases, neither the leased asset nor the lease liability is reported in the balance sheet.

Question 15-5

The criteria are: (1) the agreement specifies that ownership of the asset transfers to the lessee, (2) the agreement contains a bargain purchase option, (3) the lease term is equal to75% or moreof the expected economic life of the asset, or (4) the present value of the minimum lease payments is equal to or greater than90% of the fair valueof the leased asset.

Question 15-6

A bargain purchase option is a provision in the lease contract that gives the lessee the option of purchasing the leased property at a “bargain” price – defined as a price sufficiently lower than the expected fair value of the property when the option becomes exercisable that the exercise of the option appears reasonably assured at the inception of the lease. Because exercise of the option appears reasonably assured, transfer of ownership is expected.

Answers to Questions (continued)

Question 15-7

The lease is a capital lease to Seminole because the present value of the minimum lease payments ($5.2 million) is greater than 90% of the fair value of the asset (90% x $5.6 million = $5.04 million). Since the additional lessor conditions also are met, it is a capital lease to Lukawitz. Furthermore it is a sales-type lease because the present value of the minimum lease payments exceeds the lessor’s cost.