INTERMEDIATE
ACCOUNTING
Seventh Canadian Edition
KIESO, WEYGANDT, WARFIELD, YOUNG, WIECEK
Prepared by:
Gabriela H. Schneider, CMA
Northern Alberta Institute of Technology
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.
Learning Objectives
15. Describe the lessee’s accounting for saleleaseback transactions (Appendix 21A).
16. Explain the classification and accounting
treatment accorded leases that involve land
as well as buildings and equipment
(Appendix 21A).
Leases
Basics of Accounting by Lessees
Leasing
Capitalization criteria
Advantages Accounting for a capital
of leasing lease
Conceptual Capital lease method
nature of a illustrated
lease
Reporting and
disclosure-capital
leases
Accounting for an
operating lease
Reporting and
disclosure-operating
leases
Perspectives
Illustration of
disclosures
Accounting by
Lessors
Economics of
leasing
Classification
Capitalization
criteria
Direct financing
lease
Sales-type lease
Operating leases
Reporting and
disclosure
Illustration of
lessor
disclosures
Illustrations
Special
of Lease
Accounting
ArrangeIssues
ments
Residual
Harmon,
values
Inc.
Bargain
Arden’s
purchase
Oven Corp.
options
Initial direct Mendotta
Truck Corp.
costs
Appleland
Current
Computer
versus
noncurrent
Unsolved
problems
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 (owned by the lessor)
• 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 or divided
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
Differing Views on
Capitalization of Leases
Do not capitalize any leased assets
– Since lessee does not own the property,
capitalization is considered inappropriate
– Since executory contracts are not capitalized,
leases should not be either
Capitalize leases that are similar to instalment
purchases
– If instalment purchases are capitalized, so
should leases with similar characteristics
Differing Views on
Capitalization of Leases
Capitalize all long-term leases
– The long-term right to use property justifies its
capitalization (property rights approach)
Capitalize firm leases where the penalty for
nonperformance is substantial
– Capitalize only “firm” or non-cancellable
contractual rights and obligations
Current Accounting Standard
• CICA standard is consistent with approach
similar to instalment purchases
• A lease that transfers substantially all the
benefits and risks of property ownership
should be capitalized
Current Accounting Standard
Basic Conclusions:
1. Characteristics indicating transfer of risks
and benefits of ownership must be identified
2. Same characteristics should apply to the
lessee and lessor
3. Leases that do not transfer substantially all
benefits and risks of ownership should not
be capitalized
Lease Classification
• Capital Lease
– Where the benefits 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
 75% of
Economic Life
Yes
Capital Lease
No
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:
•
•
•
•
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 estimated and 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 rate lessor used
to calculate the lease payment, and it is less
than the lessee’s incremental borrowing rate
– In this case, use implicit 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
– Otherwise over the term of the lease
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
• 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.
Obligations under capital lease
To record interest amortization
Dr. Interest Expense
Cr.
Interest Payable
Using the Effective
Interest Method
Using method
To record asset amortization
appropriate to
Dr. Amortization Expense
Cr.
Accumulated Amortization the asset
To record the lease payment
Dr. Related Executory Expense (if any)
Dr. Interest Payable
Dr. Obligations under capital lease
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
Yes
Capital Lease
PV of payments (n=5, i=10%)
25,981.62 - 2000.00 =
23,981.62 x 4.16986 =
$100,000.00
Capital Lease - Example
• Entry to record initial lease transaction
Leased Equipment
Lease Liability
100,000
100,000
• Entry to record initial payment (Jan 1/05)
Property Tax Expense
Lease Liability
Cash
2,000.00
23,981.62
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, 2005)
Interest Expense
Interest Payable
7,601.84
7,601.84
(100,000-23,981.62)*10% = 7,601.84
(Interest Payable is debited in all subsequent lease payment entries)
• Asset amortization (December 31, 2005)
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 related accumulated
amortization
• Amortization expense may be disclosed, methods and
rate should be disclosed
• Lease obligations reported separately from other
liabilities
• Current portion of lease obligation=current liability
• 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?
Remaining
unreimburseable
Risk
associated
Yes costs to
Lessor
with collection
estimatible?
normal?
No
Yes
Does Asset
Fair Value =
Lessor’s
Book Value?
No
Yes
Direct
Financing
Lease
No
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
• Lessor replaces investment in asset to be leased
with a lease receivable
• Over lease term, the receivable is collected, and
interest is earned
• Net investment in the lease = lease payments
receivable – unearned interest revenue
Calculation of Lease Payment by
Lessor
Step 1:
Calculate the payment required to provide lessor with
required rate of return
Cost/FMV of asset to be recovered $100,000
Less: PV of expected residue value
-0Amount to be recovered through
lease payments
$100,000
Calculation of Lease Payment
(Cont’d)
Amount to be recovered
$100,000
Payments: (n=5, i=10)
$100,000
4.16986
= $23,981.62
Lease payments receivable:
5 x $23,981.62
= $119,908.10
Direct Financing Lease (Lessor)
• The lease payments 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:
Direct Financing Lease (Lessor)
January 1, 2005
Lease Payments Receivable 119,908.10
Equipment for Lease
100,000.00
Unearned Interest Revenue
19,908.10
January 1, 2005 (first payment)
Cash ($23,981.62+$2,000) 25,981.62
Property Tax Expense
2,000.00
Lease Payments Receivable
23,981.62
December 31, 2005
Unearned Interest Revenue 7,601.84
Interest Revenue
7,601.84
Direct Financing Lease (Lessor)
At Dec. 31/05 year end, Lessor recognizes interest
earned:
Amount originally financed $100,000.00
Paid on principal Jan. 1/05
(23,981.62)
Balance outstanding
$ 76,018.38
Interest : 10% x 76,018.38 x 12/12
= $7,601.84
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
• Lessor earns a gross profit on sale +
interest as the sale is financed
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 cost 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, 2005
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, 2005 (first payment-remains the same)
Cash ($23,981.62+$2,000)
25,981.62
Property Tax Expense
2,000.00
Lease Payments Receivable
23,981.62
December 31, 2005 (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 amortization of the property
– Amount of rental (lease) income earned
Other Lease Accounting Issues
• Residual Value – Lessor
– 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 (and
COGS) if guaranteed
Other Lease Accounting Issues
• Residual Value – Lessee
– If guaranteed by lessee, p.v. of residual is
included in asset cost and lease obligation
recognized (i.e. is included in definition of
minimum lease payments)
– If not guaranteed by lessee, residual value is
not included in definition of minimum lease
payments – not in asset or liability amounts
recognized
Other Lease Accounting Issues
• Bargain Purchase Option
– With direct financing and sales-type leases, the
bargain purchase price is included in the net
investment calculations by Lessor
– Lessee accounting assumes bargain option price
will be paid: p.v. of amount included in asset cost
and obligation recognized
Initial Direct Costs of Lessor
• Application of Matching Principle
– Operating lease – over term of lease
– Direct financing lease – over term of lease
– Sales-type lease – in same period as gross
profit on sale recognized
Current and Noncurrent
• Current portion = principal amount to be
received/paid within 12 months from balance
sheet date + interest accrued to the balance
sheet date
• Long-term = principal amount not
recoverable/payable within 12 months from
balance sheet date
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