Chapter 20
Accounting for Leases
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(Slide 1 of 6)
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Leasing has an important effect on companies’ financial statements.
For accounting purposes, GAAP defines a lease as
‘‘an agreement conveying the right to use property, plant, or equipment (land or depreciable assets or both) usually for a stated period of time.’’ A lease involves both a lessee and a lessor:
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A lessee acquires the right to use the leased asset in exchange for making future lease payments.
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A lessor gives up the right to use the leased asset in exchange for the receipt of future lease payments.
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(Slide 2 of 6)
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U.S. GAAP classifies leases in two types: operating and capital.
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The basic concept of GAAP is that a lease that transfers substantially all the risks and benefits of ownership is in economic substance a purchase by the lessee and a sale by the lessor. This type of lease is classified as a capital lease . Using the concept of economic substance over legal form, a capital lease is viewed by the lessee as an asset acquisition and the incurrence of a related liability to make future payments. From the lessor’s perspective, it is viewed as either the sale of an asset and the creation of a financial instrument (a receivable under a sales-type lease) or as only the creation of a financial instrument (a receivable under a direct financing lease).
A lease that does not transfer substantially all the risks and benefits of ownership is classified as an operating lease . An operating lease is viewed by both the lessee and the lessor as a rental agreement, conveying the rights to use an asset for a finite period, but not conveying the majority of the benefits or risks of the asset.
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(Slide 3 of 6)
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GAAP specifies that the lease is considered to have transferred the substantial risks and benefits of ownership if it meets any one of the following four capitalization criteria :
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The lease transfers ownership of the property to the lessee by the end of the lease term.
The lease contains a bargain purchase option.
The lease term is equal to 75% or more of the estimated economic life of the leased property.
The present value of the minimum lease payments is equal to 90% or more of the fair value of the leased property to the lessor.
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(Slide 4 of 6)
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The fourth criterion refers to the present value of the minimum lease payments.
For the lessee, minimum lease payments are the payments that are expected to be made over the life of the lease, including:
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 minimum periodic payments required by the lease over the lease term payment required by a bargain purchase option (if one exists) any guaranteed residual value any payments resulting from failure to renew or extend the lease
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(Slide 5 of 6)
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If the lease meets none of the four capitalization criteria, a transfer of the majority of the risks and benefits of the asset is considered not to have occurred, the lease is classified as an operating lease, and the lessee does not recognize an asset or a liability.
Under an operating lease, the lessee simply recognizes rent expense each period.
To qualify as a capital lease for the lessor, a second step is added to the decision framework.
A lessor classifies a lease as a capital lease if it meets any one of the four capitalization criteria that were listed previously and both of following recognition criteria are met:
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The collectability of the minimum lease payments is reasonably assured
(i.e., predictable).
No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease.
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(Slide 6 of 6)
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If the lease is classified as a capital lease, the lessor will account for it as either a sales-type capital lease or a direct-financing capital lease. A sales-type capital lease results in a manufacturer’s or dealer’s profit (or loss) that is recorded by the lessor.
A profit (loss) exists when the fair value of the leased property at the inception of the lease is greater (less) than its cost or carrying value.
In a direct-financing capital lease , there is no manufacturer’s or dealer’s profit.
For the lessor, the lease is an operating lease only if the lease meets none of the capitalization criteria or fails one of the recognition criteria.
In this case, the lessor does not recognize a sale or a receivable, and the leased asset remains on its balance sheet.
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(Slide 1 of 7)
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The main disadvantage of leasing for the lessee is that it is usually more expensive in the long run to lease an asset than to buy an asset.
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From the lessee’s point of view, the advantages (and disadvantages) of leasing may result from financing and strategic issues and include risk reduction and tax issues.
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However the main issue for many lessees revolves around financial reporting.
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(Slide 2 of 7)
Financing Issues
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A lease normally provides 100% financing, so that the lessee acquires the use of the asset by making little or no initial cash payment.
However, the lessor usually charges a higher rate for this benefit.
Strategic Issues
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Many companies cannot afford or do not want the cash outflows associated with purchasing.
Some companies, like Starbucks, prefer to lease a location for only
10 years, so they do not have to expend capital to buy the asset.
In addition, leases provide an exit option (if a location is not successful) that may be less costly than if the company was required to sell the location.
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(Slide 3 of 7)
Risk Reduction Issues Tax Issues
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The lease may allow the lessee to reduce risk.
One of the greatest risks in purchasing an asset, especially a technology asset, is obsolescence risk, or the risk that the asset will no longer be competitive.
Many times, leases are structured so that if equipment becomes obsolete, the lessee can return it or substitute newer equipment.
By doing this, the lease transfers risk from the lessee to the lessor.
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By deducting lease payments, the lessee can write off the full cost of the asset.
If property is being leased, this means the deductible lease payment includes a cost of using the land (which would not be depreciable if owned).
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(Slide 4 of 7)
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Financial Reporting Issues
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For operating leases, the lease does not add a liability or asset to the lessee’s balance sheet (although operating lease commitments are required note disclosures).
Therefore, it does not affect certain liquidity and financial leverage ratios that use balance sheet and income statement data, such as the current ratio, the debt-to-asset ratio, the debtequity ratio, and, in most cases, the rate of return on assets.
As a result, these ratios tend to be ‘‘better’’ because the leased asset and liability are omitted from the balance sheet.
In particular, omitting the liability from the balance sheet may add to the perceived borrowing capacity of the lessee.
However, financial analysts can use footnote data to adjust reported balance sheet amounts to include lease commitments before computing these ratios, which reduces this advantage.
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For an operating lease, the asset remains on the lessor’s balance sheet.
The lessor also recognizes rent revenue periodically, usually at an amount equal to the amount of the rent receipts.
For a capital lease, the lessor treats the asset as ‘‘sold’’ and records the related receivable. These alternatives affect the financial statements and ratios of the lessor.
From the lessor’s point of view, the main advantages and disadvantages of leasing an asset relative to selling the asset are as follows:
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Leasing provides a method of indirectly making a sale while still maintaining many of the advantages of ownership, including security in the asset and tax benefits.
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Leasing is a profit opportunity in a transaction that enables the lessor company to transfer an asset by the lease agreement. This transfer also permits the lessor to earn a rate of return in the form of interest on the selling price of the leased asset.
A disadvantage for the lessor is the additional risk of 100% financing and obsolescence that result from the lease contract.
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(Slide 1 of 4)
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Bargain purchase option. A contract provision allowing the lessee to purchase the leased asset at the end of the life of the lease at a price so favorable that the exercise of the option appears, at the inception of the lease, to be reasonably assured.
Bargain renewal option.
A contract provision allowing the lessee to renew the lease for a rental that is so favorable that the exercise of the option by the lessee appears, at the inception of the lease, to be reasonably assured.
Estimated economic life of leased asset.
Regardless of the lease term, the estimated remaining period during which the asset is expected to be usable for the purpose that was intended at the inception of the lease, with normal repairs and maintenance.
Estimated residual value of leased asset. The estimated fair value of the leased asset at the end of the lease term. (Note that this value is a different concept from the estimated residual value at the end of the economic life of the asset.)
Executory costs.
Costs, such as insurance, maintenance, and property taxes, that may be paid either by the lessor or the lessee. Normally, it is expected that the cost should be borne by the party to the contract who controls the asset essentially in the manner of an owner.
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(Slide 2 of 4)
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Fair value of leased asset. The price that would be received to sell the asset in an orderly transaction between market participants that are independent of the lessor.
If the lessor is a manufacturer or dealer, the fair value of the asset at the inception of the lease is normally the selling price. If the lessor is not a manufacturer or dealer, the fair value is usually the cost of the asset to the lessor.
Guaranteed residual value.
The portion of the estimated residual value of the leased asset that is guaranteed by the lessee or by a third party unrelated to the lessor.
Inception of the lease.
The date of the lease agreement; or, if the leased asset is being constructed, the date that title passes to the lessor.
Initial direct costs. Costs incurred by the lessor to originate a lease. These costs also include costs directly related to specified activities performed by the lessor for that lease, such as evaluating the lessee’s financial condition, negotiating lease terms, preparing and processing lease documents, and closing the transaction.
Interest rate implicit in the lease.
The interest (discount) rate that, when applied on a present value basis to the sum of the minimum lease payments and any unguaranteed residual value accruing to the lessor, causes the resulting total present value to be equal to the fair value of the leased asset to the lessor.
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(Slide 3 of 4)
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Lease receivable (gross investment in the lease). The sum of the undiscounted (1) minimum lease payments plus (2) any unguaranteed residual value accruing to the benefit of the lessor at the end of the lease.
Lease term. The fixed, noncancelable term of the lease plus (1) any periods covered by bargain renewal options, (2) any periods for which failure to renew the lease imposes a significant penalty on the lessee, (3) any periods covered by ordinary renewal options preceding the exercise date of a bargain purchase option, and (4) any periods during which the lessor has the option to renew or to extend the lease. The lease term, however, in no case extends beyond the date a bargain purchase option becomes exercisable.
Lessee’s incremental borrowing rate. The rate that, at the inception of the lease, the lessee would have incurred to borrow, over a similar term, the cash necessary to purchase the leased asset.
Manufacturer’s profit (loss) [dealer’s profit (loss)].
This profit or loss is the difference between the following two items: (1) the fair value of the asset at the inception of the lease and (2) the cost or carrying amount of the leased asset.
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(Slide 4 of 4)
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Minimum lease payments. These are the payments that are required to be paid by the lessee to the lessor over the life of the lease. Specifically, for a lease that contains a bargain purchase option, the minimum lease payments also include the payment required by the bargain purchase option. Otherwise, the minimum lease payments include (1) the minimum periodic payments plus (2) any guaranteed residual value and (3) any payments on failure to renew or extend the lease. Executory costs are not included in minimum lease payments.
Noncancelable lease term.
The portion of the lease term that is cancelable only under any of the following conditions (1) the occurrence of some remote contingency, (2) permission of the lessor, (3) the lessee enters into a new lease with the same lessor, or (4) the lessee incurs a penalty in such amount that continuation of the lease appears, at inception, reasonably assured.
Unguaranteed residual value. The portion of the estimated residual value of the leased asset that is not guaranteed by the lessee or by a third party unrelated to the lessor.
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Leases are often structured so that the lessee pays a set rental payment each period plus an additional amount based on usage or determined by a change in an index, like the consumer price index.
These additional payments are termed contingent rental payments because they are contingent on some future event occurring.
If the contingent rental payments are included in an operating lease agreement, the rental payments should be expensed when it is likely the contingency will be met.
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When equipment is leased under a capital lease, the lessee records, at the beginning of the lease term, an asset and a liability equal to the sum of the present value of the minimum lease payments during the lease term.
In accounting for the asset and liability, the lessee must consider the
 executory costs
 the discount rate
 amortization of the leased asset
 reduction of the lease obligation.
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Costs such as insurance, maintenance, and property taxes are called executory costs .
Executory costs may be paid by either the lessee or the lessor, depending on how the lease contract is written.
However, because the risks and benefits of ownership have been transferred in a capital lease, the lessee usually incurs these costs and many capital leases provide for the lessee to pay the executory costs directly.
Alternatively, the lessor may pay the executory costs directly and add them to the periodic lease amounts.
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In this situation, the lessee excludes the executory costs from the minimum lease payments.
Therefore, the minimum lease payment is the lease payment minus the executory costs paid by the lessor.
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The lessee computes the present value of the minimum lease payments by using the lower of either the:
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 lessee’s incremental borrowing rate lessor’s implicit interest rate in the lease, if known by the lessee
(or if it is practicable for the lessee to learn)
The incremental borrowing rate is the interest rate that the lessee normally would pay if it were to borrow money to finance the purchase of the asset (e.g., the interest rate on a secured loan with the asset as collateral for the same term as the life of the lease).
The implicit interest rate is the interest rate used by the lessor to compute the minimum lease payments necessary to recover the fair value of the leased asset.
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If a capital lease contains contingent rental payments,
GAAP either includes or excludes them from the minimum lease payment based on the type of contingency:
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If the contingent rental payment is based on usage of the asset, such as percentage of sales, number of copies made, or miles driven, the contingent rental payment is excluded from the minimum lease payments.
If the contingent rental payment is based a rate or index, such as an inflation index or government interest rate, the contingent rental payment is included in the minimum lease payments. Any difference between the actual lease payment and the estimated payment is expensed.
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Because the lessee records a long-lived asset, it must recognize an expense for the use of the asset by systematically allocating the cost of the asset over its service life.
The leased asset may be depreciated over the economic life of the asset or the lease term.
The lessee depreciates the asset over its estimated economic life to its estimated residual value if the capital lease agreement either:
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 transfers ownership of the asset to the lessee includes a bargain purchase option
If the capital lease does not transfer ownership of the asset to the lessee and does not include a bargain purchase option, the lessee depreciates the leased asset over the lease term because its right to the use of the asset ceases at the end of the lease.
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Because the lessee records a liability, it computes interest expense and the reduction of the principal for each lease payment using the effective interest method.
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This method computes interest expense each period by applying the discount rate (either the incremental borrowing rate or the implicit interest rate, as appropriate) to the outstanding balance of the lease obligation at the beginning of each period.
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When a lessee classifies its capital lease obligation on its balance sheet, it considers the usual criteria for classifying the lease as current or noncurrent. Because
GAAP provides no guidelines to measure the respective amounts, a lessee may use two approaches to measure the amount of the current liability:
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Under the present value of next year’s payments approach, the amount of the lessee’s current liability is the payment(s) the lessee will make in the next year discounted to the balance sheet date.
Under the change in present value approach, the current liability is the amount by which the total balance of the lease liability will decrease in the next year.
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The lessee may agree to guarantee part or all of the residual value.
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That is, it guarantees that the value of the leased asset at the end of the lease term will be at least the stated amount of the guarantee.
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If the asset is not worth this guaranteed value, the lessee must pay the lessor any difference between this smaller value and the guaranteed value.
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If a lessee records a lease as an operating lease, it classifies each lease payment as a cash outflow in the operating activities section of its statement of cash flows.
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If a lessee records a lease as a capital lease, it reports a noncash investing and financing activity at the signing of the lease agreement.
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For each lease payment, it classifies the portion of each cash outflow that reduces the lease obligation as a cash outflow in the financing activities section.
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A lessor classifies a lease as follows:
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Operating Lease. A lease that does not meet any of the capitalization criteria or does not meet both of the recognition criteria.
Sales-Type Capital Lease. A sales-type lease results in a manufacturer’s or dealer’s profit (or loss) and meets one or more of the capitalization criteria and both of the recognition criteria.
Direct Financing Capital Lease. A direct financing lease does not result in a manufacturer’s or dealer’s profit (or loss) and meets one or more of the capitalization criteria and both of the recognition criteria.
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Under an operating lease, a lessor retains substantially all the risks and benefits of ownership.
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The lessor keeps the leased asset on its balance sheet and reports it as a noncurrent asset separate from property, plant, and equipment held for the lessor’s own use.
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Initial direct costs are costs that a lessor incurs directly for negotiating and originating a lease.
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These costs include such things as legal fees, credit verification fees, and commissions.
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For an operating lease, the lessor records these costs as an asset and allocates them as an operating expense in proportion to the rental receipts over the term of the operating lease.
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(Slide 1 of 2)
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Under a direct financing lease, the lessor is usually a financial institution (or a financial subsidiary of a manufacturing company).
The lessor treats the lease as a sale of the asset at a fair value equal to its cost or carrying value and records an accompanying receivable.
Because there is no manufacturer’s or dealer’s profit (or loss) in a direct financing lease, the net amount at which the lessor records the receivable must be equal to the cost or carrying value of the property.
The net receivable is equal to the present value of the future lease payments to be received.
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(Slide 2 of 2)
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There are two components of the net receivable.
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The first component is the gross receivable (the total undiscounted cash flows) and is composed of both:
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Undiscounted minimum lease payments to be received by the lessor
Any unguaranteed residual value accruing to the benefit of the lessor
The second component is the unearned interest (the interest to be earned over the life of the lease)
The gross receivable includes the residual value, whether guaranteed or unguaranteed.
If the residual value is guaranteed, it is included in the minimum lease payments.
If it is unguaranteed, it is explicitly included as the second item.
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The accounting for initial direct costs incurred by the lessor is different for each of the main types of leases. For an operating lease, the lessor records these initial direct costs as an asset and allocates them as an operating expense over the term of the operating lease.
For a direct financing lease, GAAP states that the initial direct costs of a completed lease transaction include incremental direct costs and certain other direct costs:
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Incremental direct costs result directly from and are essential to the leasing transaction and would not have been incurred by the lessor if the transaction had not occurred.
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The other direct costs that may be included are those costs of the lessor related to evaluating the lessee’s financial condition, negotiating terms, preparing and processing lease documents, and closing the transaction.
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In a sales-type lease, like a direct financing lease, the lessor ‘‘sells’’ the asset and records a receivable.
A sales-type lease differs from a direct financing lease in that the fair value of the asset is greater (or less) than its cost or carrying value resulting in manufacturer’s profit (loss) [dealer’s profit (loss)].
The manufacturer’s or dealer’s profit or loss is the difference between the following two items:
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 present value of the minimum lease payments computed at the interest rate implicit in the lease (i.e., the sale proceeds) cost or carrying value of the asset plus any initial direct costs minus the present value of the unguaranteed residual value accruing to the benefit of the lessor
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The accounting for the lessor’s initial direct costs is different under a sales-type lease.
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If a lessor does incur initial direct costs on a salestype lease, it expenses them in the period in which the lease is initiated.
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The lessor may report the initial direct costs in one of two ways:
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Added to the expense Cost of Asset Leased
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Included as a selling expense entitled Initial Direct
Sales-Type Lease Expense
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The lessor deducts the present value of any unguaranteed residual value from the cost or carrying value of the asset when it recognizes the expenses associated with the signing of the lease.
The unguaranteed residual value is not included in sales revenue because it represents a portion of the asset that is not sold.
The present value of any guaranteed residual value, on the other hand, is not subtracted from the expenses (e.g., Cost of Asset Leased) and is included in sales.
Because both the expense and the revenue items contain the present value of the guaranteed residual value, the gross profit is the same as if the residual value is unguaranteed.
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A lessor reviews the estimated unguaranteed residual value annually.
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A lessor ignores any upward adjustments in the estimated value, but must record any downward adjustment as a reduction in its net investment and a loss in the period.
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This recognition involves the calculation of a new implicit interest rate.
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If a lessor records a lease as an operating lease, it classifies each lease receipt as a cash inflow in the operating activities section of its statement of cash flows.
If a lessor records a lease as a direct financing lease, it classifies any cash paid to purchase the asset as a cash outflow in the investing activities section.
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For each lease receipt, it classifies the interest portion as a cash inflow in the operating activities section and the reduction of the lease receivable as a cash inflow in the investing activities section.
If a lessor records a lease as a sales-type lease, it classifies any cash paid to purchase the asset as a cash outflow in the operating activities section.
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For each lease receipt, it classifies the receipt as a cash inflow in the operating activities section.
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