INTERMEDIATE
ACCOUNTING
Sixth Canadian Edition
KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK
Prepared by
Gabriela H. Schneider, CMA; Grant MacEwan College
CHAPTER
21
Leases
Learning Objectives
1. Explain the nature, economic substance, and
advantages of lease transactions.
2. Identify and explain the accounting criteria and
procedures for capitalizing leases by the lessee.
3. Identify the lessee’s disclosure requirements for
capital leases.
4. Identify the lessee’s accounting and disclosure
requirements for an operating lease.
Learning Objectives
5. Contrast the operating and capitalization methods
of recording leases.
6. Calculate the lease payment required for the
lessor to earn a given return.
7. Identify the classifications of leases for the lessor.
8. Describe the lessor’s accounting for direct
financing leases.
9. Describe the lessor’s accounting for sales-type
leases.
Learning Objectives
10. Describe the lessor’s accounting for operating
leases.
11. Identify the lessor’s disclosure requirements.
12. Describe the effect of residual values,
guaranteed and unguaranteed, on lease
accounting.
13. Describe the effect of bargain purchase options
on lease accounting.
14. Describe the lessor’s accounting treatment for
initial direct costs.
Leases
Basics of
Leasing
Advantages
of leasing
Conceptual
nature of a
lease
Accounting by
Lessees
Capitalization
criteria
Accounting for a
capital lease
Capital lease
method illustrated
Reporting and
disclosure-capital
leases
Accounting for an
operating lease
Reporting and
disclosureoperating lease
Illustration of
disclosures
Accounting by Special
Illustrations
Lessor
Accounting of Lease
Economics of
Arrangements
Issues
leasing
Residual Harmon, Inc.
Classification
values
Capitalization
Bargain
Arden’s Oven
criteria
purchase
Corp.
Direct financing options
lease
Initial direct Mendotta
Sales-type lease costs
Truck Corp.
Operating leases Current
Appleland
versus
Reporting and
noncurrent
Computer
disclosure
Unsolved
Illustration of
problems
lessor
disclosures
Leasing: Basics
• The lease is a contractual agreement
between the lessor and the lessee
• The lease gives the lessee the right to use
specific property
• The lease specifies also the duration of the
lease and rental payments
• The obligations for taxes, insurance, and
maintenance may be assumed by the lessor
or the lessee
Advantages of Leasing
• 100 percent financing at a fixed rate
• No down payment required
• Rate charged is fixed for the term of the lease
• Protection from obsolescence
• Property can be upgraded
• Flexibility
• Lease may be structured to meet different needs
(e.g., cash flow)
• Less costly financing (lessee); tax incentives
(lessor)
• Off-balance sheet financing
• Impact on ratios
Lease Classification
• Capital Lease
• Where the rights and risks of ownership
have effectively been transferred to the
lessee
• Accounted for as a purchase by the lessee
• Journal Entries:
Lessee
Leased Equipment XXX
Lease Obligation
XXX
Lessor
Lease Receivable (net) XXX
Equipment
XXX
Lease Classification
• Operating Lease
• Where the rights and risks of ownership
have not been transferred
• A rental-only has occured
• Journal Entries:
Lessee
Lease Expense
XXX
Cash
XXX
Lessor
Cash
XXX
Rental Revenue
XXX
Capital vs. Operating Lease
Lease
Agreement
Is there a
Transfer of
Ownership
or Bargain
Purchase
Option?
Yes
No
Is Lease Term  No
75% of
Economic Life
Yes
Capital Lease
Is Present
Value of
Payments 
90% of Fair
Value
Yes
Operating
Lease
No
Capital Lease Criteria
• Transfer of ownership
• Economic life
• PV of payments
• If the PV of minimum lease payments is  90% of
the fair value of the asset
• minimum lease payments (lessee) defined as:
• Minimum rental payments +
• Guaranteed residual value +
• Penalty for not renewing or extending lease +
• Bargain purchase option
Minimum Lease Payments
• Minimum rental payments
• Regular payment made to lessor, excluding
executory costs
• Executory costs include insurance, maintenance and
tax expenses
• If these payments made by the lessor, they are
excluded from the minimum rental payment calculation
• Guaranteed residual value
• The amount at which the lessor has the right to
require the lessee to purchase the asset; or
• The amount the lessee (or 3rd party guarantor)
guarantees that the lessor will realize
Discount Rate
• The rate the lessee would have incurred if
they had borrowed the funds to purchase the
asset (incremental borrowing rate)
• Under similar term (length)
• Similar security (same type of asset)
• This rate is not used when
• The lessee knows the implicit borrowing rate
lessor used to calculate the lease payment, and
• The implicit borrowing rate is less than the
incremental borrowing rate
Accounting for a
Capital Lease
• Asset and liability recorded at the lower of:
• PV of the minimum lease payments (as defined above)
or
• Fair value of the asset at the inception of the lease
• Depreciation of the asset is amortized over:
• The economic life of the asset if ownership transfers
to lessee at the end of the lease or there is a bargain
purchase option
• The term of the lease if title does not transfer or there
is no bargain purchase option
Accounting for a
Capital Lease
• Interest expense resulting from the lease
transaction is recorded following the
effective interest method
• The discount rate used to establish the initial
PV is used to amortize the lease discount
• Journal entries required to record a capital
lease transaction are as follows:
Accounting for a
Capital Lease
At the inception of the lease
Dr. Asset
Cr.
Lease Liability
To record interest amortization
Dr. Interest Expense
Cr.
Interest Payable
Using the
Effective
Interest Method
To record asset amortization
Dr. Amortization Expense
Cr.
Accumulated Amortization
Using method
appropriate to
the asset
To record the lease payment
Dr. Related Executory Expense (if any)
Dr. Interest Payable
Dr. Lease Liability
Cr.
Cash
Capital Lease - Example
Lease Terms Given:
• Term of 5 years, non-cancellable
• Annual payments $25,981.62 (due at beginning of each
year)
• Fair value of asset $100,000
• Economic life = 5 years
Residual value = Zero
• Lease payments include $2,000 property taxes (executory
cost)
• Lease has no renewal option, and asset reverts to Lessor
at termination of lease
• Lessee’s incremental borrowing rate = 11%
• Lessor’s implicit rate =10% (known to lessee)
Capital Lease - Example
• Does this qualify as a capital lease?
• Only one of the tests must be met
Is there a
Transfer of
Ownership
or Bargain
Purchase
Option?
No
Is Lease Term
 75% of
Economic
Life?
Is Present
Value of
Payments 
90% of Fair
Value?
Yes
Capital Lease
Yes
PV of payments (n=5, i=10%)
25,981.62 - 2000.00 =
23,981.62 * 4.16986 =
$100,000.00
Capital Lease - Example
• Entry to record initial lease transaction
Leased Equipment
100,000
Lease Liability
100,000
• Entry to record initial payment (Jan 1/02)
Property Tax Expense
2,000.00
Lease Liability
23,981.62
Cash
25,981.62
• As this is a capital lease the following must also
be recorded (at year end or in each reporting period)
• Interest expense
• Asset amortization
Capital Lease - Example
• Interest amortization (December 31, 2002)
Interest Expense
7,601.84
Interest Payable
7,601.84
(100,000-23,981.62)*10% = 7,601.84
(Interest Payable is debited, and becomes part of all
subsequent lease payments)
• Asset amortization (December 31, 2002)
Amortization expense 20,000
Accumulated amortization 20,000
(100,000 ) / 5 years = 20,000)
(There is no transfer of ownership or bargain purchase
option, so the term of the lease is used to amortize the
asset)
Disclosure Requirements –
Capital Lease
• Gross amount of assets and accumulated
amortization
• Depreciation expense may be disclosed, methods
and rate should be disclosed
• Lease obligations reported separately from other
liabilities
• Current portion of lease obligation
• Minimum lease payments in total and for the next
five fiscal years; executory costs and imputed
interest disclosed separately
• Interest expense from the lease may be separately
disclosed; or included with other interest expense
• May disclose any related contingencies
Accounting by the Lessor
• Leases are classified as either:
• Operating Lease
• Direct financing Lease
• Sales-type Lease
These are
capital leases
• The determination of a capital or operating
lease depends on answering a series of
questions
Lease Classification - Lessor
Lease
Agreement
Does Lease
meet any of
Lessee’s
Capital
Lease
criteria?
No
Risk
associated
with collection
normal?
Remaining
unreimburseable costs
Yes to Lessor
estimatible?
Does Asset
Fair Value =
Lessor’s Book
Value?
Yes
No
No
Yes
Direct
Financing
Lease
No
Operating
Lease
Yes
Sales-Type
Lease
Lease Classification - Lessor
• Both the direct financing lease and the salestype lease are capital leases
• The difference is whether or not there exists
a manufacturer’s or dealer’s profit
• The sales-type lease incorporates a profit –
hence the final question on the previous map
• A lease may qualify as a capital lease by the
lessee and as an operating lease by the lessor
Direct Financing Lease - Lessor
• Accounting entries are a virtual mirror
image of the capital lease entries for the
lessee
• A couple of differences:
• The lease payment must first be calculated
• The discount rate used to establish the
Receivable is the rate of return of the lessor
• Unearned Interest Revenue is credited with
the difference between the Receivable and the
Asset credit
Capital Lease –
Example (Lessor)
• Step One – Calculate the annual lease payment
required to provide the required rate of return
Cost (FMV)
$100,000
Less: PV of the Salvage
0
Amount to be Recovered
$100,000
• Payments would then be:
$100,000
=
$23,981.62
1.46986 Annuity due factor for n=5, i=10%
• Total payments receivable = 5 * 23,981.62
= 119,908.10
Capital Lease –
Example (Lessor)
• The lease payment receivable are equal to:
Lease payments (net of executory costs) +
salvage (residual) value
• The unearned interest revenue is the
difference between the lease payment
receivable and the asset cost (FMV)
• The journal entries are then:
Capital Lease –
Example (Lessor)
• January 1, 2002
Lease Payments Receivable
119,908.10
Equipment for Lease
100,000.00
Unearned Interest Revenue
19,908.10
• January 1, 2002 (first payment)
Cash ($23,981.62+$2,000)
25,981.62
Executory Costs
2,000.00
Lease Payments Receivable
23,981.62
• December 31, 2002
Unearned Interest Revenue
7,601.84
Interest Revenue
7,601.84
Sales-Type Lease - Lessor
• Entries are the same as for the direct
financing lease, except for:
• Entry at the inception of the lease must
record the sale and cost of goods sold
• Recall that the sales-type lease includes a
manufacturer’s/dealer’s profit margin
Sales-Type Lease – Example
• Take the same data as in our example,
except the asset has been recorded in
the Lessor’s inventory at a value of
$85,000 (FMV=$100,000)
• All previous lessor entries remain the
same except for the entry at the lease
inception
• Sales and Gross Profit are recorded
Sales-Type Lease – Example
• January 1, 2002
Lease Payments Receivable 119,908.10
Sales
100,000.00
Unearned Interest Revenue
19,908.10
Cost of Goods Sold
85,000.00
Inventory
85,000.00
• January 1, 2002 (first payment-remains the same)
Cash ($23,981.62+$2,000) 25,981.62
Executory Costs
2,000.00
Lease Payments Receivable
23,981.62
• December 31, 2002 (remains the same)
Unearned Interest Revenue 7,601.84
Interest Revenue
7,601.84
Disclosure Requirements Lessor
• Disclose the net investment in the lease
(classified as current and non-current)
• How the investment is calculated for
purposes of income recognition
• Finance income amount
• Operating Leases
• Separate disclosure of the cost and
accumulated depreciation of the property
• Amount of rental (lease) income earned
Other Lease Accounting Issues
• Residual Value
• Direct Financing Lease: whether guaranteed or
unguaranteed, the residual is included in the lessor
calculations
• Sales-Type Lease: with unguaranteed residual value
the Sales Revenue and COGS are reduced by the PV of
that unguaranteed residual value
Residual value is part of Sales Revenue if guaranteed
• Bargain Purchase Option
• With direct financing and sales-type leases, the bargain
purchase price is included in the net investment
calculations
• Direct Costs of Lessor
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