21 Accounting for Leases

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Chapter 21: Accounting for LeasesChapter 21: Accounting for Leases

Intermediate Accounting, 11th ed.Kieso, Weygandt, and Warfield

Prepared byJep Robertson and Renae Clark

New Mexico State University


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1. Explain the nature, economic substance, andadvantages of lease transactions.

2. Describe the accounting criteria and

procedures for capitalizing leases by the lessee.

3. Contrast the operating and capitalizationmethods of recording leases.

4. Identify the classifications of leases for the

lessor.

After studying this chapter, you shouldbe able to:



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5. Describe the lessors accounting fordirect-financing leases.

6. Identify special features of leasearrangements that cause uniqueaccounting problems.

7. Describe the effect of residual values,guaranteed and unguaranteed, on lease

accounting.8. Describe the lessors accounting for

sales-type leases.

9. Describe the disclosure requirements for

leases.



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The lease is a contractual agreement

between the lessor and the lessee.

The lease gives the lessee the right to usespecific property.

The lease specifies the duration of the

lease and rental payments.

The obligations for taxes, insurance, andmaintenance may be assumed by the lessor

or the lessee.

Leasing: BasicsLeasing: Basics


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1. Leases may not require any money down.

2. Lease payments are often fixed.

3. Leases reduce the risk of obsolescence tothe lessee.

4. Leases may contain less restrictivecovenants than other types of lendingarrangements.

5. Leases may be a less costly means offinancing.

6. Certain leases may not add to existingdebt on the balance sheet.

Advantages of LeasingAdvantages of Leasing


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According to the FASB: a lease transferring substantially all of the

benefits and risks of ownership should becapitalized.

Transfer of ownership can be assumed onlyif there is a high degree of performance to

the transfer, that is, the lease is non-cancelable.

Leases that do not substantially transfersbenefits and risks are operating leases.

Conceptual Nature of a LeaseConceptual Nature of a Lease


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Leases that meet anyof thefollowing four criteria are capital

leases for the lessee:1. Leases, transferring ownership

2. Leases with bargain purchase options

3. Leases with lease terms equal to 75% or

more of the economic life (75% rule)4. Leases where the present value of lease

payments is equal to 90% or more of thefair market value (90% rule)

Accounting by LesseeAccounting by Lessee


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Lease Agreement

Is there transfer

of ownership?Yes

Is there a bargain

purchase option?

YesNo

Is lease term equalto or greater than75% of economic

life ?

Yes

No

Capital

Lease

Operating

Lease

Is present valueof payments

equal to or more

than 90% FMV?

Yes

No

Accounting by LesseeAccounting by Lessee


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A bargain purchase option

allows the lessee to buy the leased asset

at a price significantly lower than theassets fair value when the option isexercisable

The difference between the option price,

and the fair value (when the option isexercisable) as determined at theinception of the lease must render theoption reasonably assured.

The Bargain Purchase OptionThe Bargain Purchase Option


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In determining the present value of thelease payments, three important factorsare considered:

1) Minimum lease payments the lessee isexpected to make under the lease,

2) Executory costs (insurance, taxes, andmaintenance), and

3) Discount rate (used by the lessee todetermine the present value of minimumlease payments)

The Recovery of Investment TestThe Recovery of Investment Test

(90% Test)(90% Test)


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The minimum lease paymentsinclude:

1) minimum rental payments (which may ormay not be equal to the minimum leasepayments)

2) guaranteed residual value at the end ofthe lease term (guaranteed the lessor bythe lessee or a third party)

3) any penalty required of the lessee forfailure to extend or renew the lease

4) any bargain purchase option given tolessee

Minimum Lease PaymentsMinimum Lease Payments


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1. The lessee computes the present value ofthe lease payments using the lesseesincremental borrowing rate.

2. If the lessee knows the lessors implicitinterest rate and it is less than thelessees incremental rate, then suchimplicit rate must be used.

3. The lessors implicit rate produces thefollowing result:

present value of (minimum lease payments andunguaranteed residual value) = fair value of the

asset to lessor

Discount RateDiscount Rate


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In a capital lease transaction, the lesseerecords an asset and a liability.

The asset is depreciated by the lessee overthe economic life of the asset.

The effective interest method is used toallocate the rental payments betweenprincipal and interest.

Depreciation of the asset and discharge ofthe lease obligation are independentaccounting procedures.

Accounting for Asset and LiabilityAccounting for Asset and Liability

by Lesseeby Lessee


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Lessor classifies leases as one of the

following:

1. Operating lease

2. Direct financing lease

3. Sales-type lease

Classification of Leases: LessorClassification of Leases: Lessor


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To be classified as an operating lease:

1. The lease doesnt meet any group 1

criteria (same as lessees), OR2. Collectibility of payments isnt reasonably

assured, OR

3. Lessors performance isnt substantially

complete.

Accounting by Lessor:Accounting by Lessor:

Classification of LeasesClassification of Leases


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To be classified as a direct financing leasethe lease must meet group 1 criteria(same as lessees), andthe following,group 2 criteria:

1. Collectibility of payments must bereasonably assured, and

2. Lessors performance must besubstantially complete, and

3. Assets fair value must be equal to lessorsbook value

Accounting by Lessor:Accounting by Lessor:

Classification of LeasesClassification of Leases


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Lease Agreement

Does lease meetGroup 1 criteria?

No

Is collectibility of

payments assured?

Noyes

Is lessorsperformancesubstantially

complete ?

No

yes

Operating

Lease

Direct

financing

Does asset FMV

equal lessors

book value?

No

yes

yes

Sales type

Lessors Criteria for LeaseLessors Criteria for Lease

ClassificationClassification


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The lessor depreciates the leased asset

according to its depreciation policy.

Maintenance costs of the leased asset(payable by lessor) are charged to expense.

Costs, such as finders fees and credit

checks, are amortized over the lease term.

The leased equipment and accumulateddepreciation are shown as Equipment

Leased to Others.

Operating Lease: LessorOperating Lease: Lessor


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The following information is needed bylessor to record a direct financing lease:Gross investment (lease payments receivable),

consisting of:the minimum lease payments and any

unguaranteed residual value at the end of leaseterm

Unearned interest revenue (difference betweengross investment and the FMV of the property)

Net investment (gross investment less unearnedinterest revenue)

Direct Financing: LessorDirect Financing: Lessor


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DirectDirect--Financing LeaseFinancing Lease


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Residual values

Sales-type leases (lessor)

Bargain purchase options

Initial direct costs

Current versus noncurrent

Disclosure

Special Accounting ProblemsSpecial Accounting Problems


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Residual value is the estimated fair value ofasset at the end of lease term

May either be guaranteed or unguaranteed

From lessors perspective once the leaserate is determined, it makes no differencewhether the residual value is guaranteed orunguaranteed.

From lessees perspective: Guaranteed residual affects minimum lease

payment calculation

Unguaranteed residual does not

Residual ValuesResidual Values


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SalesSales--Type LeaseType Lease


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Two types:

Incremental directs costs paid to third

parties at origination of lease

Internal direct costs paid by lessor at

origination of lease.

Initial Direct CostsInitial Direct Costs


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For the lessee, the requirements forcapital leases are:

gross amount of assets future minimum lease payments

total non-cancelable minimum subleaserentals

total contingent rentals identify assets separately

general description of lesseesarrangements

Disclosure Requirements: LesseeDisclosure Requirements: Lessee


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For the lessor, the requirements forsales-type and direct-financing leases

are: components of net investment

future minimum lease payments

amount of unearned revenue included in

revenue total contingent rentals

general description of lessors leasingarrangements

Disclosure Requirements: LessorDisclosure Requirements: Lessor


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For the lessor, the requirements foroperating leases:

cost and carrying amount

minimum future rentals

total contingent rentals

general description of lessors leasing

arrangements

Disclosure Requirements: LessorDisclosure Requirements: Lessor


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