Chapter 20 Accounting for Leases

Advantages of Leasing from the Lessees Viewpoint

1. Financing Benefits
a. The lease provides 100% financing, so the there is no down payment
required.
b. The lease contracts contain fewer restrictions and provisions making it
more flexible than other debt agreements
c. The leasing arrangement creates a claim that is against only the leased
equipment and not all assets.
2. Risk Benefit. The Lease may reduce the risk of obsolescence and inadequacy.
3. Tax Benefit. By deducting lease payments, the lessee can write off the full cost of
the asset including the part that relates to land.
4. Financial Reporting Benefit. In certain cases (for operating leases), the lease
does not add a liability to the lessees balance sheet and does not affect certain
financial ratios such as rate of return.
5. Billing Benefit. For certain contract-type work, leasing may permit the contractor
to charge more because the interest element contained in the rental payments is
allowed as a contract charge, whereas interest on borrowed money to purchase
assets is usually not.

Advantages of Leasing form Lessors Viewpoint

1. A way of indirectly making a sale
2. An alternative means of obtaining profit opportunity by engaging in a transaction
that enables the lessor company to transfer an asset by the lease agreement.

Accounting By Lessee
Operating Lease
An operating lease is a lease that does not meet any one of the four criteria listed in
Column A of Exhibit 20-2 (text).
Under the Operating Lease method the Lessee does not capitalize the asset, only a lease
expense is recorded.

Capital Lease
In order the lessee to capitalize a lease it must be noncancelable and meet one of the
following four requirements:
1. The lease transfers ownership to the lessee.
2. The lease contains a bargain purchase option
3. The lease term is equal to 75% or more of the estimated economic life of the
leased property.
4. The present value of the minimum lease payments (excluding executory costs)
equals or exceeds 90% of the fair value of the leased property.
If the lease is capital the lessee records an asset and a liability equal to the sum of the
present value at the beginning of the lease term, of the minimum lease payments during
the lease term.

Accounting By Lessor
From the standpoint of the Lessor, all leases may be classified for accounting purposes as
one of the following:
1. Operating Lease
2. Direct Financing Lease
3. Sales-Type Lease
Capitalization Criteria (Lessor)
Group I
1. The lease transfers ownership of the property to the lessee.
2. The lease contains a bargain purchase option
3. The lease term is equal to 75% or more of the estimated economic life of the
leased property.
4. The present value of the minimum lease payments (excluding executory costs)
equals or exceeds 90% of the fair value of leased property.
Group II
1. Collectibility of the payments required from the lessee is reasonably predictable
2. No important uncertainties surround the amount of unreimbursable costs yet to be
incurred by the lessor under the lease (lessors performance is substantially
complete or future costs are reasonably predictable.
If at the date of the lease agreement the lessor is party to a lease the meets one or
more of the Group I requirements and both of the Group II criteria, the lessor shall
classify the lease as a direct financing lease or a sales type lease.

From this point, if the lease includes manufacturers or dealers profit(loss) it is

considered to be a sales-type lease. If it does not it is considered a direct financing
lease.
All leases that do not qualify as a direct financing or sales-type lease are classified as
an operating lease.
Operating Lease (Lessor)

Under and operating lease, a lessor company leasing an asset to a lessee retains
substantially all the risks and benefits of ownership.

Rental receipts are recorded as rental revenue.

The leased asset is depreciated in the normal manner and the expense of the period is
matched against rental revenue.

Direct Financing Leases (Lessor)

The net amount at which the lessor records the receivable must be equal to the cost of
carrying value the property.

Then net receivable is equal to the present value of the future leas payments to be
received.

There are two components of the net receivable, gross receivable and the unearned
interest.

The gross receivable of the lessor includes the lessor includes the sum of:
o The undiscounted minimum lease payments to be received by the lessor
(net of executory cost paid by the lessor) plus
o The unguaranteed residual value accruing to the benefit of the lessor.

The interest rate implicit in the lease is the rate that, when applied to the gross
receivable, will discount that amount to a present value that is equal to the net
receivable.

Initial Direct Cost Involved in a Direct Financing Lease of a completed lease

transaction include incremental direct cost and certain other direct costs. Incremental
direct cost include those cost that result directly from and are essential to the leasing
transaction and would not have been incurred by the lessor if the transaction had not
occurred.

Sales-Type Leases (Lessor)

In distinguishing between a sales-type lease and a direct financing lease, the major
differences are the presence of a manufacturers or dealers profit or loss in a saletype lease and the accounting for initial direct costs.

The manufacturers profit of loss is measured as the difference between the following
two items:
o The present value of the minimum lease payments (net of executory costs)
computed at the interest rate implicit in the lease
o The cost or the carrying value of the asset plus any initial direct costs less
the present value of the unguaranteed residual value accruing to the
benefit of the lessor.