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Leases
Learning Objectives
 Describe the circumstances in which
leasing makes more business sense than
does an outright sale and purchase.
 Understand the accounting issues faced by
the asset owner (lessor) and the asset user
(lessee) in recording a lease transaction.
 Outline the types of contractual provisions
typically included in lease agreements.
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Learning Objectives
 Apply the lease classification criteria in
order to distinguish between capital and
operating leases.
 Properly account for both capital and
operating leases from the standpoint of
the lessee (asset user).
 Properly account for both capital and
operating leases from the standpoint of
the lessor (asset owner).
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Learning Objectives
 Prepare and interpret the lease disclosures
required of both lessors and lessees.
 Compare the treatment of accounting for
leases in the United States with the
requirements of international accounting
standards.
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Learning Objectives
EXPANDED MATERIAL
 Record a sale-leaseback transaction for
both a seller-lessee and a purchaserlessor.
 Recognize the special characteristics of
real estate leases.
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Lease
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A contract specifying
the terms under which
the owner of an asset
agrees to transfer the
right to use the asset
to another party.
Assets Acquired by Leasing
• Lessee: The party granted the right to use
the property under the terms of a lease.
• Lessor: The owner of the property that is
rented (leased) to another party.
• Operating Lease: A simple rental
agreement.
• Capital Lease: A leasing transaction that is
recorded as a purchase by the lessee.
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Economic Advantages of Leasing
• No down payment.
• Avoid risks of
ownership.
• Flexibility.
Advantages to Lessor
• Increased sales.
• Ongoing business
relationship with
lessee.
• Residual valued
retained.
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Lease Provisions
Cancellation
Provision
Bargain Purchase
Option
Lease Term
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Specifies under what
circumstances the lease
may be canceled.
Grants lessee the right to
purchase the asset at the
end of the lease term for less
than the residual value.
Delineates the time period
the lease is to be in force.
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Lease Provisions
Residual Value
Market value of leased
asset at end of lease term.
Minimum Lease
Payment
Rental payment required
over lease term plus any
payment for residual value.
Lease Classification Criteria
A lease is classified as a
capital lease by the lessee if
it is noncancelable and meets
any one of the following
criteria:
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Lease Classification Criteria
 The lease transfers ownership of the leased
asset to the lessee by the end of the lease term.
 The lease contains an option allowing the
lessee to purchase the asset at the end of the
lease term at a bargain price.
 The lease term is equal to 75 percent or more
of the estimated economic life of the asset.
 The present value of the lease payments at the
beginning of the lease is 90 percent or more of
the fair market value of the leased asset.
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Lease Classification--Lessee
Yes
Transfer of Ownership?
Yes
No
Bargain Purchase
Option?
Yes
No
Term >75% of
Useful Life?
Yes
No
PV Payment >90%
of FMV?
Capital
Lease
No
Operating
Lease
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Lease Classification--Lessor
Additional revenue recognition
criteria applicable to lessors.
 Collectibility of the minimum lease
payments is reasonably predictable.
 No important uncertainties surround the
amount of unreimbursable costs yet to be
incurred by lessor.
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Example: Operating Lease
Bob Jones signs a two-year lease which requires
a monthly payment of $1,000. When the lease
expires, Bob will either move out or negotiate a
new lease.
Lessee
Rent (or Lease) Expense
1,000
Cash
1,000
To record monthly rent on
office building.
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Example: Operating Lease
Bob Jones signs a two-year lease which requires
a monthly payment of $1,000. When the lease
expires, Bob will either move out or negotiate a
new lease.
Lessor
Cash
1,000
Rent Revenue
1,000
To record monthly rent on
office building.
Operating Leases With Varying
Lease Payments
The terms of a lease for an
aircraft by International Airlines
provide for payments of
$150,000 a year for the first two
years and $250,000 for each of
the next three years.
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Operating Leases With Varying
Lease Payments
Entry Each Year for Years 1 and 2:
Rent Expense
210,000
Cash
150,000
Rent Payable
60,000
Entry Each Year for Years 3-5:
Rent Expense
210,000
Rent Payable
40,000
Cash
250,000
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Interest Rates for Discounting
Lease Payments
 Implicit Interest Rate: Rate that
would be used to discount the
minimum lease payments to the fair
market value of the leased asset at the
inception of the lease.
 Incremental Borrowing Rate: Rate
at which lessee could borrow the
amount of money necessary to
purchase the leased asset.
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Interest Rates for Discounting
Lease Payments
Lessor always
uses the implicit
rate to discount
rental payments.
Lessee uses the
lesser of the
implicit rate and
the incremental
borrowing rate.
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Accounting for Capital Leases
The Lessee
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Example: Leases
•
•
•
•
•
•
Minimum Payment
$1,000/year
Executory Costs
$100
Term
10 years
Useful Life of Asset
10 years
Implicit Rate
10%
Incremental Borrowing Rate
12%
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Example: Inception of the Lease
Leased Equipment
Obligations under Capital
Leases
6,759
6,759
(PV of $1,000 in arrears for 10 years at 10%.)
Lease Expense
Obligations under Capital
Leases
Cash
100
1,000
1,100
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Example: End of Year 1
Prepaid Executory Costs
Obligations under Capital
Leases
Interest Expense
Cash
100
Amortization Expense
Acc. Amortization
615
424
576
1,100
(Straight-line amortization of leased asset.)
615
Choosing an Amortization
Period for Leased Assets
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Amortize Over
FASB 13 Criterion Met
Title passes at end of lease term
Lease contains bargain purchase
option
Term of life  75% of asset’s
useful life
Present value of payments  90%
of asset’s fair market value
Useful
Life
Lease
Term
X
X
X
X
Bargain Purchase Option
Frequently, the lessee
is given the option of
purchasing the
property in the future
at what appears to be
a bargain price.
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Bargain Purchase Option
The present value of
the bargain purchase
option would be
added to the present
value of the minimum
lease payments to
establish the initial
asset and liability.
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Impact of a Capital Lease on 29
Lessee’s Statement of Cash Flows
Operating Activities (indirect)
Net income
(includes reduction for
Lease interest expense
Lease amortization expense)
+ Amortization of leased asset
Investing Activities
No impact
Financing Activities
Principal portion of lease payment
Impact of a Capital Lease on 30
Lessee’s Statement of Cash Flows
Operating Activities (direct)
- Lease interest expense
Investing Activities
No impact
Financing Activities
- Principal portion of
lease payment
Accounting for Capital Leases
The Lessor
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Treatment of Initial
Direct Costs
Type of Lease
Operating
Direct
interest, over
Sales-Type
as
Accounting Treatment of Costs
Capitalize and amortize over
lease term.
Capitalize and amortize,
Financing with unearned
lease term.
Immediately recognize cost
reduction in profits.
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Accounting for Direct
Financing Leases
•
•
•
•
•
•
Minimum Payment
$1,000/year
Executory Costs
$100
Term
10 years
Useful Life of Asset
10 years
Implicit Rate
10%
Incremental Borrowing Rate
12%
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Example: Direct Financing
Lease
At Inception of Lease:
Lease Payments Receivable
Equipment Purchased for
Lease
Unearned Interest Revenue
At Receipt of First Payment:
Cash
Lease Payments Receivable
Executory Costs
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10,000
6,759
3,241
1,100
1,000
100
Example: Direct Financing
Lease
At End of the First Year:
Cash
Lease Payments Receivable
Deferred Executory Costs
Unearned Interest Revenue
Interest Revenue
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1,100
1,000
100
576
576
Direct Financing Lease
If the lessor incurs any
initial direct costs, those
costs are recorded as a
separate asset.
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Accounting for
Sales-Type Leases
(Continues example introduced in lessee section)
•
•
•
•
•
•
•
Minimum Payment
$1,000/year
Executory Costs
$100
Term
10 years
Useful Life of Asset
10 years
Implicit Rate
10%
Incremental Borrowing Rate
12%
Cost of Equipment
$5,000
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Sales-Type Lease
Transaction Components
Minimum Lease Payments
$10,000
Fair Market Value of Leased Asset
$ 6,759
$ 3,421
Financing
Revenue
(Interest)
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Sales-Type Lease
Transaction Components
Minimum Lease Payments
$10,000
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$ 3,421
Financing
Revenue
(Interest)
Fair Market Value of Leased Asset
$ 6,759
Cost of Leased Asset to Lessor
$ 5,000
$ 1,759
Manufacturer’s
or Dealer’s
Profit
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Sales-Type Lease
To Record the Sale:
Lease Payments Receivable 10,000
Unearned Interest Revenue
3,431
Sales
6,569
To Remove the Inventory and Record Cost:
Cost of Goods Sold
Finished Goods Inventory
5,000
5,000
Sales-Type Lease With BPO or
Guaranteed Residual Value
If the agreement provides for the
lessor to receive a lump sum (from
a bargain purchase option) at the
end of the lease term or a
guaranteed residual value, the
minimum lease payments include
these amounts.
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Sales-Type Lease With BPO or
Guaranteed Residual Value
The receivable is increased by
the gross amount of the bargain
purchase option or the
guaranteed residual value.
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Summary of Lease Impact on
Statement of Cash Flows
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Indirect Direct Investing Financing
Method Method Activities Activities
Lessee:
Operating lease
NI
payments
Capital lease:
Lease payments-NI
interest
Lease payments-principal
Amortization of
asset
+ NI
- Cash
- Cash
- Cash
No
impact
Summary of Lease Impact on
Statement of Cash Flows
Lessor:
Operating lease:
Initial direct costs (IDC)
Amortization of IDC
Lease receipts
Direct financing lease:
Initial direct costs
Amortization of IDC
Lease receipts--interest
Lease receipts--principal
Indirect
Method
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Direct Investing
Method Activities
- Cash
+NI
NI
No impact
+ Cash
- Cash
+ NI
NI
No impact
+ Cash
+ Cash
Summary of Lease Impact on
Statement of Cash Flows
Lessor:
Sales-type lease:
Initial direct costs
Manufacturer’s or
dealer’s profit (net of
IDC)
Lease receipts--interest
Lease receipts--principal
Indirect
Method
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Direct Investing
Method Activities
- Cash
- NI
NI
+ NI
No impact
+ Cash
+ Cash
Sale-Leaseback Transactions
An arrangement whereby one party sells
property to a second party, and then the first
party leases the property back is a saleleaseback transaction.
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Real Estate Leases
Yes
Is lease
for land only
or building
only?
Does lease
meet criterion
1 and 2?
Yes
Capitalize lease if
lessee. Report as a
sales-type or a direct
financing lease if
lessor and supplementary criteria met.
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Real Estate Leases
Yes
Is lease
for land only
or building
only?
Does lease
meet criterion
1 and 2?
No
Allocate rents to land
and building
Next slide
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Real Estate Leases
Allocate rent to land
and building
Land
Building
Capitalize lease if lessee. Lessor reports a
sales-type or a direct financing lease if
supplementary criteria met.
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Real Estate Leases
Does lease
meet criterion
1 and 2?
Allocate rents to land
and building
Next slide
No
Yes
Is land more
than 25% of
total value?
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Real Estate Leases
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Allocate rent to land
and building
Building
Does lease
meet criterion
3 or 4?
Land
Capitalize lease
(lessor must
Yes
meet
supplementary
criteria).
Real Estate Leases
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Allocate rent to land
and building
Building
Does lease
meet criterion
3 or 4?
Land
No
Operating lease
Real Estate Leases
Does lease
meet criterion
1 and 2?
Does lease
meet
criterion 3
or 4?
No
No
No
Operating lease
Is land more
than 25% of
total value?
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Real Estate Leases
Does lease
meet criterion
1 and 2?
Does lease
meet
criterion 3
or 4?
No
No
Is land more
than 25% of
total value?
Yes
Capitalize lease (lessor must
meet supplementary criteria).
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The End