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LEASE ACCOUNTING -LESSEE
POLICY PERSPECTIVE
A Lease is defined as an agreement conveying the right to use property, plant, or
equipment (land and/or depreciable assets) for a stated period of time. This
document describes the two classifications (Capitalized and Operating) and the
accounting treatment required for leases where the company is the lessee, plus
sale/leaseback and subleases.
POLICY
If at its inception a lease meets one or more of the following four criteria, the
lease shall be classified as a capital lease:
A.
The lease transfers ownership of the property to the company by the end
of the lease term.
B.
The lease contains a bargain purchase option.
C.
The lease term is equal to 75% or more of the estimated asset life of the
leased property. This criterion does not apply if the beginning of the lease
term falls within the last 25% of the asset life.
D.
The present value (PV) of the minimum lease payments at the lease
inception date equals or exceeds 90% of the fair value of the leased
property at the lease inception less any related investment tax credit
retained by the lessor. Minimum lease payments exclude executory costs
such as insurance, maintenance, and taxes to be paid by the lessor and
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profit thereon. This criterion does not apply if the beginning of the lease
term falls within the last 25% of the asset life.
The company should have a preferred provider for all lease arrangements by its
business units. The preferred provider should be contacted whenever a business
unit is considering leasing arrangements. The preferred provider should be
utilized whenever they provide competitive contract terms, interest rates, etc., to
the company.
POLICY STATEMENTS
1.
Upon expiration of the lease term, any renewal/extension/change in
provision of the lease is to be treated as a new lease.
2.
A lease agreement which meets the capitalization criteria and whose annual
rental payment is less than $2,500 (U.S.) should not be capitalized but rather
treated as an operating lease. Leases covering multiple-like assets (e.g.,
auto and fleet leases) are subject to the dollar limitation in the aggregate.
3.
International organizations with nonaffiliated rental expense less than
$250,000 and that meet the conditions set forth in the Alternative Accounting
Criteria Policy are to account for the lease agreements under the “operating
lease” method.
Accounting Treatment for Capitalized Leases
4.
The lessee (the company) is to compute the present value of the minimum
lease payments using his incremental borrowing rate, unless (i) the implicit
rate can be readily obtained from the lessor and (ii) the implicit rate obtained
from the lessor is less than the lessee's incremental borrowing rate. If both of
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these conditions are met, the lessee is to use the lessor's implicit rate for the
present value computation.
5.
The lessee (the company) is to record a capital lease as an asset and a
liability. The amount should equal the lower of the PV of the minimum lease
payments at the lease inception date excluding executory costs and profit
thereon or the fair value of the leased property at the lease inception date. If
executory costs including profit are indeterminate, they are to be estimated
where practical.
6.
When fair value is the amount to be capitalized, the interest rate implicit in
the minimum lease payments should be used to determine the portion of
each lease payment which is principal and which is interest. When present
value is the amount to be capitalized, the interest rate determined in Policy
Statement 5 should be used to allocate the portion of each lease payment
which is principal and which is interest.
7.
If either the first or second criterion of a capitalized lease is met, the
depreciation period is to be the estimated asset life of the leased property. If
the lease does not meet either the first or second criterion, the asset is to be
depreciated over the lease term.
8.
Prior to the expiration of the lease term, termination of a capital lease is to
be accounted for by removing the asset and liability and recognizing a gain
or loss for the difference.
9.
If at its inception a lease does not meet at least one of the four criteria of a
capitalized lease, the lease is to be classified as an operating lease. Rental
on an operating lease is to be charged to expense over the lease term on a
straight-Iine basis.
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Leases Involving Real Estate
10. If land is the sole item of property leased and either the first or second
criterion of a capitalized lease is met, the lease is to be accounted for as a
capital lease. The asset recorded will not be depreciated. Criteria Three and
Four of a capital lease are not applicable to land only leases.
11. For lease agreements that meet either the first or second criterion of a
capitalized lease, the land and buildings are to be separately capitalized by
the lessee. The present value of the minimum lease payments, less
executory costs and profits thereon, are to be allocated between the two
elements in proportion of their fair values at the inception of the lease. The
building is to be depreciated on a straight-Iine basis over its asset life. Land
capitalized under a lease that meets the first or second criterion of a
capitalized lease will not be depreciated.
12. For a lease that meets neither the first nor second criterion but meets either
the third or fourth criterion of a capitalized lease then the land and building
elements are to be capitalized as a single unit (building capital lease) and
depreciated over the length of the lease term.
13. For real estate leases whose term is less than or equal to ten years, criteria
"C" and "D" need not be applied.
14. For lease agreements involving equipment as well as real estate, the portion
of the minimum lease payments applicable to the equipment of the lease is
to be estimated and the equipment is to be considered separately for
purposes of applying the criteria of a capitalized lease and the equipment
and real estate shall be accounted for separately.
15. If the cost and fair value of the leased property involving only part of a
building are objectively determinable, the lease is to be classified and
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accounted for according to the provisions of Policy Statement 12. If both the
cost and the fair value are not objectively determinable, the lease is
classified and accounted for as follows:
-
If the fair value of a leased property is objectively determinable, the lessee
should classify and account for the lease according to the provisions of
Policy Statement 12.
-
If the fair value of the leased property is not objectively determinable, the
lessee should classify the lease according to the third criterion of a
capitalized lease only, using the estimated asset life of the building in
which the leased premises are located. If the lease term is equal to 75%
or more of the estimated asset life of the leased property, the leased
property should be capitalized as a unit and depreciated over the lease
term. Otherwise, the lease should be treated as an operating lease.
Sale and Leaseback
16. A sale-leaseback transaction occurs when the company sells owned
property to an outside party and concurrently enters into an agreement to
leaseback that property (such as buildings). If the lease meets one of the
four criteria for treatment as a capital lease, the seller-lessee (the company)
should account for the lease as a capital lease--otherwise as an operating
lease. Additionally, any profit on the sale shall be deferred and amortized in
proportion to the depreciation of the leased asset, if a capital lease, or in
proportion to rental payments over the period of time the asset is expected
to be used, if an operating lease. Any loss on the sale is to be recognized
immediately.
Sublease and Similar Transactions
17. If the company is relieved of the primary obligation under the original lease
(by substitution of a new lessee through a new agreement), the termination
of the original lease agreement is accounted for as follows:
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- If the original lease was a capital lease, the asset and liability representing
the original lease should be removed from the accounts and gain or loss
should be recognized for the difference. If the original lessee (the
company) is secondarily liable, the loss contingency should be treated as
per the policy regarding "Contingencies." Any consideration paid or
received upon termination is included in the determination of gain or loss
to be recognized.
- If the original lease was an operating lease and the original lessee (the
company) is secondarily liable, the loss contingency should be treated as
provided by Corporate Finance and Accounting Policy regarding
"Contingencies."
- If the original lessee (the company) is not relieved of the primary liability
under the original lease, the original lessee (the company), as sublessor,
should continue to account for the original lease as previously established.
- When a leased property is no longer useful to the original lessee, causing
either a sublease or abandonment, a provision for any losses, which can
be reasonably estimated, should be recorded by the sublessor or original
lessee. The loss should include all costs directly related to the decision to
abandon or sublease the facility including rental payments (net of rental
income) and capitalized leasehold improvements to the extent any
improvements have no substantive future use or benefit to the company.
Inter-company Leases
18. Inter-company rentals should be structured and accounted for as operating
leases.
Disclosure Requirements
19. Extensive public disclosure rules are currently in force for leases. The
company must comply with these rules; therefore, division/group records
must be maintained on file at the local level supporting capital/operating
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lease classification decisions. In addition, sufficient documentation must also
be available to permit the following disclosures:
- For Capital Leases:
- The gross amount of assets recorded under capital leases. These
amounts must be segregated by balance sheet date and by land,
buildings, and machinery and equipment.
- The aggregate total of future net minimum lease payments as of the
latest balance sheet date and for each of the five succeeding fiscal
years plus the balance applicable to later years. Separate deductions
must be shown for the imputed interest necessary to reduce the net
minimum payments to present value.
- The total minimum sublease rentals to be received in the future under
non-cancelable subleases as of the date of the latest balance sheet
presented.
- For operating leases having initial or remaining non-cancelable lease
terms in excess of one year:
- The aggregate total of future minimum rental payments for leases in
force as of the latest balance sheet date and for each of the five
succeeding fiscal years plus the balance applicable to later years.
- The total minimum rentals to be received in the future under noncancelable subleases as of the date of the latest balance sheet
presented.
- For all operating leases, the following information is to be separately
maintained for rental expense for each period for which an income
statement is presented with separate amounts for:
- Minimum rentals
- Contingent rentals -Rentals on which the amounts are dependent
on some factor other than the passage of time. If a minimum rental is
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established, the contingent rental is the amount in excess of the
minimum rental.
- Sublease rentals
- Rental payments under leases with terms of a month or less that were
not renewed need not be included.
-
For Capital and Operating Leases, a general description of the lessee's
leasing arrangements including, but not limited to, the following is to be
maintained:
- The basis on which contingent rental payments are determined.
- The existence and terms of renewal or purchase options and
escalation clauses.
- Restrictions imposed by lease agreements, such as those
concerning dividends, additional debt, and further leasing.
POLICY SUPPLEMENT
1.
The following terms/definitions apply to this policy:
-
Asset Life -Refers to the company’s financial depreciation lives for
fixed assets.
-
Bargain Purchase Option -A provision allowing the lessee, at his
option, to purchase the leased property for a price which is
sufficiently lower than the expected fair value of the property at the
date the option becomes exercisable so that exercise of the option
appears, at the lease inception, to be reasonably assured.
-
Bargain Renewal Option -A provision allowing the lessee at his
option to renew the lease for a rental sufficiently lower than the fair
rental of the property at the date the option becomes exercisable so
that exercise of the option appears, at the inception of the lease, to
be reasonably assured.
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-
Capital Lease -An agreement whereby the lessee acquires
substantial, long term rights to the use of property under lease.
Specific criteria for a capital lease are described in the policy.
-
Executory Costs -Insurance, maintenance, and taxes to be paid by
the lessor, including profit thereon.
-
Fair Value of the Leased Property -The price for which the property
could be sold in an arm's length transaction between unrelated
parties. Fair value of leased property should be obtained from the
lessor wherever possible. However, in those limited situations
where fair value is unavailable to the company, a special appraisal
is not required. For land and buildings, the fair value should be
reasonably estimated after contact with Corporate Real Estate
Division.
-
Imputed Interest to the company -Difference between the Total Net
Minimum Lease Payments and the lesser of the present value of
the Net Minimum Lease Payments or the Fair Value of the leased
property.
-
Inception of the Lease -The date of the lease agreement or
commitment if earlier. An agreement or commitment shall be in
writing, signed by the parties in interest to the transaction, and shall
specifically set forth the principal provisions of the transaction.
-
Lease Term -Initial Term of Lease (the fixed non-cancelable term of
the lease) plus Extended Term Options: [a) all periods covered by
bargain renewal options, b) all periods for which failure to renew the
lease imposes a penalty on the lessee such that the renewal
appears at the inception of the lease to be reasonably assured, c)
all periods covered by ordinary renewal options during which a
guarantee by the lessee of the lessor's debt related to the leased
property is expected to be in effect, d) all periods covered by
ordinary renewal options preceding the date when a bargain
purchase option is exercisable, and e) all periods covering renewals
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or extensions of the lease at the lessor's option up to the date when
a bargain purchase option is exercisable.
-
Lessee -Company or individual granted a lease.
-
Lessee's Incremental Borrowing Rate -The rate that the company
would have incurred to borrow over a similar term the funds
necessary to purchase the leased asset.
-
Lessor- Company or individual granting a lease.
-
Lessor's Implicit Rate -That rate which, when used to discount the
minimum lease payments and residual value of leased property to
the lessor, to their aggregate present value at lease inception, will
provide a result equal to the fair value of the leased property less
any investment tax credit retained by the lessor.
-
Minimum Lease Payments -The payments that the lessee is
obligated to make or can be required to make in connection with the
leased property. This includes:
o Minimum Rental Payments -The rental payments called for by
the lease over the lease term.
o Guarantees -Any residual value at the expiration of the lease
term guaranteed by the lessee. This requirement is in effect
whether or not payment of the residual constitutes a purchase of
the leased property.
o Bargain Purchase Options -Any bargain purchase amount (an
option allowing the lessee to purchase the leased property for a
price which is sufficiently lower than the expected fair value of the
Property at the date the option becomes exercisable so that
exercise of the option appears, at the lease inception, to be
reasonably assured).
o Penalty -Any payment that the lessee (the company) must make
or can be required to make upon failure to renew or extend the
lease at the expiration of the lease term. This requirement is in
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effect whether or not the payment would constitute a purchase of
the leased property.
-
Minimum Sublease Rentals -When property is subleased by the
Company to another party, the minimum rental amount per the
agreement.
-
Net Minimum Lease Payments -Minimum Rental Payments plus
Bargain Purchase Options, plus Guarantee and Penalty amounts,
less Executory Costs.
-
Operating Lease -A temporary or cancelable agreement whereby
the lessee agrees to make periodic payments to the lessor for use
of property. True ownership interest is retained by the lessor.
-
Present Value of Net Minimum Lease Payments -Total net
minimum lease payments for each period discounted at the
appropriate discount rate.
-
Residual Value of Leased Property to Lessor -The estimated
remaining value of the lease property, at the end of the lease term,
exclusive of any portion guaranteed by the lessee which is deemed
to be recoverable by the lessor based on price levels existing at the
lease inception date.
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Policy Statement 5
Illustration of a Capitalized Lease -Machinery and Equipment
Example Data
-Minimum rental payments over the lease term
$231,905
-Fair value of the property at the inception of the lease
$205,000
-Estimated asset life of the property
5 years
-Non-cancelable lease term
5 years
-Rent payable annually at the beginning of the year
$ 46,381
-Lessee's incremental borrowing rate
8%
-Lessor's implicit rate (residual value of leased property to lessor:
8 1/2%
$9,250)
-Maintenance, property taxes, and insurance are paid by the lessee.
Amortization Schedule:
Annual
Interest On
Payment On
Unpaid
Rental
Unpaid Principal
Principal
Balance
Jan. 1, 20X1
$200,000
Jan. 1, 20X2
$ 46,381
0
$ 46,381
$153,619
Jan. 1, 20X2
$ 46,381
$12,290 (8% x $153,619)
$ 34,091
$119,528
Jan. 1, 20X3
$ 46,381
$ 9,562 (8% x $119,528)
$ 36,819
$ 82,709
Jan. 1, 20X4
$ 46,381
$ 6,617 (8% x $82,709)
$ 39,764
$ 42,945
Jan. 1, 20X5
$ 46,381
$ 3.436 (8% x $42,945)
$ 42,945
$
$231.905
$31.905
$200,000
0
Computation of Present Value of Rent Payments:
$46,381 rent payable annually at the beginning of the year for five years at 8%
interest. When rent is payable at the beginning of the year, there is no discount
back from the first rent payment, so there is one less discount period than the
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number of rent payments. Therefore, the discount periods used in this example
are (5 1) or 4.
Using an ordinary annuity table below, the present value of rent payments is
computed as follows.
PV = (Discount rate x annual rent payment) + first rent payment
PV = (3.312 x $46,381) + $46,381
PV = $153,614 + $46,381
PV = $200,000 rounded
Present Value of Annuity of $1 (Ordinary)
Received annually at the end of each period for n periods.
Years
Discount Rates
n
2%
4%
6%
8%
10%
1
0.980
0.962
0.943
0.926
0.909
2
1.942
1.886
1.833
1.783
1.736
3
2.884
2.775
2.673
2.577
2.487
4
3.808
3.630
3.465
3,312
3.170
5
4.713
4.452
4.212
3.993
3.791
6
5.601
5.242
4.917
4.623
4.355
7
6.247
6.002
5.582
5.206
4.868
8
7.325
6.733
6.210
5.747
5.335
9
8.162
7.435
6.802
6.247
5.759
10
8.983
8.111
7.360
6.710
6.145
NOTE: If the rent is payable annually at the end of the year, the discount periods
will equal the number of rent payments on the Present Value Table for an
Ordinary Annuity of $1.
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Classification of the Lease Agreement as a Capital Lease:
-
Criterion One not met. The lease does not transfer ownership of the property
to the lessee by the end of the lease term .
-
Criterion Two not met. The lease does not contain a bargain purchase
option.
-
Criterion Three met. The lease term of five years is more than 75% of the
asset life of the property which is also five years.
-
Criterion Four met. The present value ($200,000) of the minimum lease
payments ($231,905) using the lessee's incremental borrowing rate of 8%
exceeds 90% of the fair value of the property at the inception of the lease
(90% of $205,000 or $184,500).
Accounting Entries. Jan. 1, 20X1:
Machinery and Equipment Capital Leases
$200,000
Non-current Installment on Capital
Lease Obligations
$ 46,381
Non-current Installment on Capital
Lease Obligations
Cash
$200,000
$46,381
To record capital lease and first annual payment
Jan. 31, 20X1:
Depreciation Machinery -Machinery
and Equipment Capital Leases
$ 3,333
Machinery and Equipment Capital
Leases -Allowance for Depreciation
$ 3,333
To record monthly depreciation ($200,000 divided by 5 divided by 12)
Non-current Installment on Capital
Lease Obligations
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$ 34,091
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Current Installment on Capital
Lease Obligations
$ 34,091
To transfer current portion of capital lease obligations out of non-current portion
of capital lease obligations.
Interest Expense -Capital Leases
$ 1,024
Current Liability -Capital Lease
Interest Payable
$ 1,024
To accrue interest expense ($12,290 divided by 12)
Jan. 1, 20X2:
Current Installment on Capital Lease
Obligations
$ 34,091
Customer Focused
Current Liability -Capital Lease
Interest Payable $ 12,290
Cash
$ 46,381
To record annual payment
Jan. 31, 20X2:
Depreciation -Machinery and Equipment
Capital Leases
$ 3,333
Machinery and Equipment Capital
Leases -Allowance for Depreciation
$ 3,333
To record monthly depreciation ($200,000 divided by 5 divided by 12)
Non-current Installment on Capital Lease
Obligations
$ 36,819
Current Installment on Capital Lease
Obligations
$ 36,819
To transfer current portion of capital lease obligations out of noncurrent portion of
capital lease obligations.
Interest Expense -Capital Leases
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$ 797
15
Current Liability -Capital Lease
Interest Payable
$ 797
To accrue interest expense ($9,562 divided by 12)
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