FA3 Lesson 5: Leases
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Capitalization criteria
Lessee: Basic lease accounting
Lessee: Fiscal year and capitalization cap
Lessee: Sale and leaseback
Lessor: Lease accounting
Cash flow statement review
1. Capitalization criteria
Central objective: Accounting should capture
the economic essence of the lease transaction.
Is the transaction essentially a rental or a sale?
Capitalization guidelines
1. Lessee owns asset at end of lease term
2. Lease term > 75% of asset useful life
3. PV of min. lease payments at least 90% of
FMV of asset
If not a capital lease, then operating lease.
Lease vocabulary
Min. lease payments: total periodic rental
payments (less executory costs) plus bargain
purchase option (BPO) or guaranteed residual
or failure to renew penalty
Interest rate: lessee incremental borrowing rate
or rate implicit in lease, whichever is lower
Residual value: value of leased asset at end of
lease
Lease term: all terms prior to exercise date of
BPO, all bargain renewal terms, all renewal
terms at lessor’s option
2. Lessee: Basic lease accounting
• For an operating lease, lessee records only rent
expense (plus any prepaid rent/rent payable)
• For a capital lease, lessee must record an asset
and liability equal to PV of min. lease
payments
• For a capital lease, lease payments represent
interest and capital repayment; asset must be
amortized over period lessee will use the asset
EXAMPLE: A18-1
3. Lessee: Fiscal year and capitalization cap
• The amortization table for lease payments will
not necessarily correspond to the fiscal year;
interest expense could be a combination of
interest from two different lease payments
• Lessee cannot record the leased asset at a
value higher than its market value; if the lessee
incremental borrowing rate is too low, must
use rate implicit in the lease (the one that sets
PV of min. lease payments equal to FMV of
asset)
Example: A18-7
4. Lessee: Sale and leaseback
• Sale and leaseback: The former owner (now
lessee) sells the asset and leases it back
immediately from lessor
• Any gain on sale to the lessee is amortized
over the lifetime of the lease, proportionately
to amortization of leased asset; any loss on
sale is recognized immediately
EXAMPLE: A18-27
5. Lessor: Lease accounting
From lessor point of view, two types of leases:
1. Direct financing lease: lessor is a finance
company that purchased the asset at fair
market value and leased it immediately to
lessee; lessor reports only financing revenue,
recognized over lifetime of lease
2. Sales-type lease: lessor is a manufacturer or
retailer who earns (1) gross profit on sale of
asset, recognized at time of sale; and (2)
financing revenue, recognized over lifetime of
lease
5. Lessor: Lease accounting (cont’d)
Accounting for direct financing leases:
1. Establish lease receivable at gross value
2. Remove leased asset from books
3. Create unearned finance revenue account for
difference between (1) and (2), a contra
account to lease receivable; any initial direct
costs charged to unearned finance revenue
4. Annually, record finance income, lessee
payment, and any other lease-related costs.
EXAMPLE: A19-25
5. Lessor: Lease accounting (cont’d)
Accounting for sales-type leases:
1. Establish lease receivable at gross value
2. Record sales revenue = fmv of asset
3. Remove asset from books and record COGS
4. Create unearned finance revenue account for
difference between (1) and (2)
5. Initial direct costs expensed as incurred
6. Annually, record finance income, lessee
payment, and any other lease-related costs.
EXAMPLE: A19-25
6. Cash flow statement review
EXAMPLE: A19-27