Running head: LEASES 1Leases ACC306 - Intermediate Accounting IINameProfessor DateRunning head: LEASES 2LeasesAccording to our text, 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 leasing arrangement. However, I firmly believe that because of the professional judgment that is needed to differentiate between leases, it is still very easy to misrepresent the truth on a firm’s balance sheet.When accounting for leases, an operating lease records no asset or liability on the financial statements and the amount paid is expensed as it is incurred. On the other hand, a capital lease is recorded as both an asset and a liability on the financial statements and generally at the present value of the rental payments. However, individuals and firms can and would abuse the recording of Operating and Capital Leases for their benefit. Therefore, the FASB made up specific guidelines that are used to determine the criteria for Capital Leases. A Capital Lease is non-cancellable and one or more of the following must be met: 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 to 75% or more of the expected economic life of the asset.4. The present value of the minimum lease payments is equal to or greater than 90% of the fair value of the leased asset (Spiceland, 2007). On the other hand, a lease is considered to be an Operating lease if the above criteria are not met. However, firms still use a lot of intentional structuring of lease contracts to avoid capitalization. Therefore, we must ask the question of “Why do lessees/firm managers want toRunning head: LEASES 3avoid putting leased assets and related liabilities on their balance sheets?” (Frecka, 2008). The answer is very simple:…Putting the leases on the balance sheet may result in violation of loan covenants, affect the amount of compensation received by managers (e.g., if compensation is linked to the firm’s earnings), result in higher-reported earnings for growing firms and it can lower rates of return and increase debt to equity ratios. All ofthese reasons relate to the desire to give the appearance that the economic performance of the firm is stronger than it really is and that capital structure risk is lower (Frecka, 2008).Therefore, the FASB is attempting to change the way leases are accounted for:NORWALK, Conn.- The Financial Accounting Standards Board Sept. 16 tentatively agreed to reconfirm its plan to propose the right-of-use model, a principles-based approach in accounting for leases, but said its views could be influenced later by different issues that arise during continuing discussions.The discussion was part of FASB's nondecisionmaking review of an analysis of comments received on the discussion paper, Leases: Preliminary Views. The discussion paper was issued jointly with the International Accounting Standards Board in March with a comment period ending July 17 (5 APPR 303, 4/3/09).For lessee accounting, it proposed to require lessees to recognize on the statement of financial position a "right-of-use asset," and a liability for an obligation to pay rentals for all leases.The right-of-use model is favored among users of financial statements who believe it would eliminate existing structuring opportunities and would result in accounting for lease arrangements based on the substance rather than the form of the transaction. (Lugo, 2009).Firstly, accounting for leases is very complex and can alter the way a lease can be accounted for. That is why we must take into account the leased assets residual value. The residual value of a lease is “The amount a company expects to be able to sell a fixed asset for at the end of its useful life.” (Investorwords.com, 2010). That means that a leased asset is only an estimate ofRunning head: LEASES 4what its true value will be at the end of the lease and is very wide open to interpretation by the individuals recording the leased asset. Also; this could mean that the minimum lease payments for the lessee exclude any residual value not guaranteed by the lessee. On the other hand, the lessor includes any residual value not guaranteed by the lessee but guaranteed by a third-party guarantor. Even when minimum lease payments are the same, their present values will differ if the lessee uses a discount rate different from the lessor’s implicit rate. This would occur if the lessee is unaware of the implicit rate or if the implicit rate exceeds the lessee’s incremental borrowing rate.Secondly, a bargain purchase option can be made available by the lessor to the lessee which is a provision in the lease contract that gives the lessee the option of purchasing the leased property at a “bargain” price. Therefore, it is 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.” (Spiceland, 2007). Thirdly, Executory costs are costs usually associated with ownership of an asset such as maintenance, insurance, and taxes. These are responsibilities of ownership that we assume are transferred to the lessee in a capital lease. When paid by the lessee, these expenditures are expensed by the lessee as incurred. When paid by the lessor, rental payments usually are inflated.These executory costs, including any lessor profits, are excluded in determining the minimum lease payments and still are expensed by the lessee, even though they are paid by the lessor.Fourthly, in an operating lease initial direct costs are recorded as prepaid expenses and amortized as an operating expense over the lease term. This approach is due to the nature of operating leases in which rental revenue is earned over the lease term. Initial direct costs areRunning head: LEASES 5matched, along with depreciation and other associated costs, with the rent revenues they help generate. However, In a direct financing lease initial direct costs are amortized over the lease term. This is accomplished by offsetting unearned revenue by the initial direct costs. This recognizes the initial direct costs at the same rate as the interest revenue to which it is related. The nature