Chapter 21: Accounting for Leases

The Leasing Environment

A lease is a contractual agreement between a lessor and a lessee, that gives
the lessee the right to use specific property, owned by the lessor, for a
specified period of time.
Largest group of leased equipment involves:
Information technology,
Transportation (trucks, aircraft, rail),
Construction and
Agriculture.
Advantages of Leasing
1. 100% Financing at Fixed Rates.
2. Protection Against Obsolescence.
3. Less Restrictive Debt Covenants.
4. Less Costly Financing.
5. Off-Balance-Sheet Financing.
Conceptual Nature of a Lease
Capitalize a lease that transfers substantially all of the risks and
benefits of property ownership, provided the lease is noncancellable.
Leases that do not transfer substantially all the risks and benefits of
ownership are operating leases.
The issue of how to report leases is the case of substance versus form.
Although legal title may not pass to the lessee, the benefits from the use of
the property do.
Operating Lease
Journal Entry:
Rent expense
Cash
Capital Lease
Journal Entry:
Leased equipment
Lease obligation

xxx
xxx

xxx
xxx

A lease that transfers substantially all of the risks and benefits of property
ownership should be capitalized (only noncancellable leases may be
capitalized).

Statement of Financial Accounting Standard No. 13, Accounting for Leases,

1976
Accounting by the Lessee
If the lessee capitalizes a lease, the lessee records an asset and a liability
generally equal to the present value of the rental payments.
Records depreciation on the leased asset.
Treats the lease payments as consisting of interest and principal.
Leases that meet any one of the following four criteria are capital
leases for the lessee:
1. Title Transfers to the lessee.
2. Lease contains a bargain purchase option.
3. Lease term is 75 percent of the estimated economic life of the
leased property.
4. The present value of the minimum lease payments (excluding
executory costs) is 90 percent of the fair market value of the
leased property.

Accounting by the Lessee

Leases that DO NOT
meet any of the four
criteria are accounted for
as Operating Leases.

Lease Agreement

No
Transfer
of
Ownership

Yes

No
Bargain
Purchase

Yes

No
Lease Term
>= 75%

Yes

Capital Lease

PV of
Payments
>= 90%

Yes

No

O
p
e
r
a
t
i
n
g
L
e
a
s
e

Present Value of the Minimum Lease Payments for Lessee

1. Exclude Executory costs (insurance, taxes, and maintenance)
from the PV calculation.
2. Include guaranteed residual value at the end of the lease term
(guaranteed by the lessee).
3. Discount rate: Use the lessees incremental borrowing rate unless
the lessors implicit rate is known to be less than the lessees

Chapter
21-8

incremental borrowing rate. (if the lessee knows both rates, use the
rate thats lower)
Accounting by the Lessee
Recovery of Investment Test (90% of FMV Test)
PV of Minimum lease payments include:
Minimum rental payment
Guaranteed residual value
Penalty for failure to renew
Bargain purchase option
Executory Costs (Exclude from PV of Minimum Lease Payment
calculation):
Insurance
Maintenance
Taxes
Lessee Depreciation Period
If Title transfers, or if there is a BPO, depreciate the asset over the
economic life of the asset.
Otherwise, depreciate over the term of the lease.
Accounting by the Lessee - EXAMPLE
(Capital Lease with Unguaranteed Residual Value) On January 1, 2013,
Burke Corporation signed a 5-year noncancelable lease for a machine. The
terms of the lease called for Burke to make annual payments of $8,668 at
the beginning of each year, starting January 1, 2013. The machine has an
estimated useful life of 6 years and a $5,000 unguaranteed residual value.
Burke uses the straight-line method of depreciation for all of its plant assets.
Burkes incremental borrowing rate is 10%, and the Lessors implicit rate is
unknown.
Instructions
(a) What type of lease is this? Explain.
(b) Compute the present value of the minimum lease payments.
(c) Prepare all journal entries for Burke through Jan. 1, 2014.

Accounting by the Lessee

Burke Corp. What type of lease is this? Explain.

Capitalization Criteria:

Capital Lease, #3

1. Transfer of ownership

NO
NO

2. Bargain purchase option

3. Lease term >= 75% of

economic life of leased

property

4. Present value of minimum

lease payments
>= 90%
Accounting
byofthe
FMV of property

Lease term
Economic life

YES

5 yrs.
6 yrs.
83.3%

FMV of leased
property is unknown.
Lessee

Burke Corp. present value of the minimum lease payments.

Chapter
21-13

Payment
Present value factor (i=10%,n=5)
PV of minimum lease payments

$ 8,668
4.16986*
$36,144

J o ur na l e nt r y
1/ 1/ 13

L e a s e d M a c h in e U n d e r C a p ita l L e a s e
L e a s e li a b i li t y
L e a s e li a b i li t y
Cash

Chapter
21-14

* PV Annuity Due, Table 6- 5.

3 6 ,1 4 4
8 ,6 6 8

3 6 ,1 4 4
8 ,6 6 8

Accounting by the Lessee

Burke Corp. Lease Amortization Schedule
L ease
Pay m ent

D ate

10 %
I nter est
E x p ense

R e d u c tio n
in L ia b ility

1/ 1/ 2 0 13

$ 3 6 ,1 4 4

1/ 1/ 2 0 13

$ 8 ,6 6 8

1/ 1/ 2 0 14

8 ,6 6 8

1/ 1/ 2 0 15
1/ 1/ 2 0 16
1/ 1/ 2 0 17

L ease
L ia b ility

$ 8 ,6 6 8

2 7 ,4 7 6

2 ,7 4 8

5 ,9 2 0

2 1 ,5 5 6

8 ,6 6 8

2 ,1 5 6

6 ,5 1 2

1 5 ,0 4 4

8 ,6 6 8

1 ,5 0 4

7 ,1 6 4

7 ,8 8 0

8 ,6 6 8
7 8 8 the 7Lessee
,8 8 0
Accounting
by

Chapter
21-15

Journal entries for Burke Corp. through Jan. 1, 2014.

J o ur na l e nt r y
12 / 3 1/ 13

D e p r e c ia tio n e x p e n s e

7 ,2 2 9

A c c u m u la t e d d e p r e c i a t i o n

7 ,2 2 9

($ 3 6 , 1 4 4 5 = $ 7 , 2 2 9 )

I n te r e s t e x p e n s e

2 ,7 4 8

I n t e r e s t p a y a b le

Accounting
Lessee
[ ( $ 3 6 , 1 4 4 $ 8 , 6 6 8by
) X . 1the
0]

2 ,7 4 8

Journal entries for Burke Corp. through Jan. 1, 2014.

Chapter
21-16

J o ur na l e nt r y
1/ 1/ 14

L e a s e li a b i li t y

5 ,9 2 0

I n t e r e s t p a y a b le

2 ,7 4 8

Cash

8 ,6 6 8

Accounting by the Lessee

Burke Corp.
Comparison of Capital Lease with Operating Lease

D ate

C a p it a l L e a s e
D e p r e c ia tio n I n te r e st
E x p ense
E x p ense

2 0 13

7 ,2 2 9

$ 2 ,7 4 8

2 0 14

7 ,2 2 9

2 ,1 5 6

2 0 15

7 ,2 2 9

2 0 16

7 ,2 2 9

2 0 17

7 ,2 2 8
$

3 6 ,1 4 4

T otal

$ 1 ,3 0 9

9 ,3 8 5

8 ,6 6 8

7 17

1 ,5 0 4

8 ,7 3 3

8 ,6 6 8

65

788

8 ,0 1 7

8 ,6 6 8

(6 5 1)

7 ,2 2 8

8 ,6 6 8

( 1 ,4 4 0 )

4 3 ,3 4 0

$ 4 3 ,3 4 0

$ 7 ,1 9 6

D if f .

8 ,6 6 8

9 ,9 7 7

O p e r a t in g
L ease
E x p ense

* rounding
Chapter
21-18

Accounting by the Lessor

Chapter
21-19

any one of the conditions in group 1 and both in group 2 are

required for a lease to be treated as a capital lease by the lessor.

Accounting by the Lessor
Classification of Leases by the Lessor
1. Operating Lease.
2. Capital Lease:
a. Direct-financing lease (no dealer profit, except interest).
b. Sales-type lease (contains dealer profit because FMV Asset >
Lessors BV of the Asset).

Accounting by the Lessor

Classification of Leases by the Lessor

A lessor may classify a lease as an operating lease but the

lessee may classify the same lease as a capital lease.
Chapter
Direct-Financing
Lease Exercise
21-21
Fieval Leasing Company signs an agreement on 1/1/10 to lease equipment to
Reid Company.
1. Term of the lease and economic life of asset is 6 years.
2. Cost and fair value of the asset is $343,000.
3. Asset will revert to lessor at end of the lease.
4. Expected RV is $61,071, none of which is guaranteed.
5. Reid Company assumes direct responsibility for executory costs.
6. Equal annual payments begin on 1/1/10 (lessor desires 10% rate of
return).
7. Group II conditions are met

Calculation of Lease Payment

Direct- Financing Lease Exercise
(Computation of Lease Payment)
R e s id u a l v a lu e

P V o f s in g le s u m (i= 1 0 % , n = 6 )
PV o f r e sid u a l va lu e

F a ir m a r k e t v a lu e o f le a s e d e q u ip m e n t
P r e s e n t v a lu e o f r e s id u a l v a lu e
A m o u n t t o b e r e c o ve r e d t h r o u g h le a s e p a y m e n t
P V f a c to r o f a n n u n ity d u e ( i= 1 0 % , n = 6 )
A n n u a l p a y m e nt r e q u ir e d

0 .5 6 4 4 7
$

3 4 ,4 7 3

3 4 3 ,0 0 0
(3 4 ,4 7 3 )

6 1 ,0 7 1

3 0 8 ,5 2 7
4 .7 9 0 7 9
$

6 4 ,4 0 0

Calculation of Lease Payment

PVChapter
=
(Payment) (PV Factor, 10%, 6) $308,527 = (Payment) (4.79079)
21-23
$308,527/4.79079 = Payment
$308,527/4.79079 = $64,400

Accounting by the Lessor

Direct- Financing Lease Exercise

Lessors Amortization Schedule

Chapter
21-25

Accounting by the Lessor

Direct- Financing Lease Exercise
J ournal entries for the lessor for 2010 and 2011:
1/1/10

Lease Receivable

343,000

Equipment
1/1/10

Cash

343,000
64,400

Lease Receivable

12/31/10

Accounting by the Lessor

Interest Receivable

64,400

27,860

Interest
Revenue
Direct- Financing
Lease
Exercise

27,860

J ournal entries for the lessor for 2010 and 2011:

Chapter
21-26

1/1/11

12/31/11

Cash

64,400

Lease Receivable

36,540

Interest Receivable

27,860

Interest Receivable
Interest Revenue

24,206
24,206

Lessee Accounting for Residual Value

The present value of the minimum lease payments includes the
Chapter
guaranteed
residual value but excludes the unguaranteed residual value.
21-27
Illustration: See previous example:
PV of Unguaranteed RV was deducted before calculating Lease
Payment.
Lessee Computations & Entries
Illustration On Jan. 1, 2006, Velde Company (lessee) entered into a fouryear, noncancellable contract to lease a computer from Exceptional
Computer Company (lessor). Annual rentals of $17,208 are to be paid each
Jan. 1. The cost of the computer to Exceptional Computer Company was
$60,000 and has an estimated useful life of four years and no residual value.
Velde has an incremental borrowing rate of 12% but has knowledge that

Exceptional computer Company used a rate of 10% in setting annual rentals.

Collection of the rentals is reasonably predictable and there are no important
uncertainties regarding future unreimbursable costs to be incurred by the
lessor.

Lessee Computations & Entries

Is this a Capital Lease to the Lessee?

I llustration (LESSEE) What type of lease is this? Explain.

Capitalization Criteria:

Capital Lease, #3

1. Transfer of ownership

NO
NO

2. Bargain purchase option

3. Lease term => 75% of

economic life of leased

property

4. Present value of minimum

lease payments => 90% of

FMV of property

Chapter
21-30

Lease term
Economic life

4 yrs.
4 yrs.
100%

YES

$17,208 * 3.48685 =
$60,000 (rounded)
FMV of leased
property is unknown.

Lessee Computations & Entries

I llustration (LESSEE) Prepare an amortization schedule

that would be suitable for Velde.

D ate

Lease
P a y m e nt

10%
I nt e r e s t
E x p e ns e

R e d u c t io n o f
L ia b ilit y

1/1/06

Chapter
21-31

L ease
L ia b ilit y
$

1/1/06

$ 17,208

1/1/07

17,208

1/1/08
1/1/09

60,000

$ 17,208

42,792

4,279

12,929

29,863

17,208

2,986

14,222

15,641

17,208

1,567

15,641

Lessee J ournal Entries

I llustration (LESSEE) Prepare all of the journal entries for
Velde for 2006 and 2007.
. J o ur na l e nt r ie s
1/ 1/ 0 6

L e a s e d c o m p u te r

6 0 ,0 0 0

L e a s e li a b i li t y
1/ 1/ 0 6

L e a s e li a b i li t y

6 0 ,0 0 0
1 7 ,2 0 8

Cash
12 / 3 1/ 0 6

I n te r e s t e x p e n s e

1 7 ,2 0 8
4 ,2 7 9

I n t e r e s t p a y a b le
12 / 3 1/ 0 6

D e p r e c ia tio n e x p e n s e

4 ,2 7 9
1 5 ,0 0 0

A c c u m u la t e d D e p r e c i a t i o n

Entries
$ 6Lessee
0,000 / 4 = J
$ 1 ournal
5,000

1 5 ,0 0 0

Chapter
21-32

I llustration (LESSEE) Prepare all of the journal entries for

the Velde for 2006 and 2007.
J o ur na l e nt r ie s
1/ 1/ 0 7

I n t e r e s t p a y a b le
L e a s e li a b i li t y

4 ,2 7 9
1 2 ,9 2 9

Cash
12 / 3 1/ 0 7

I n te r e s t e x p e n s e

1 7 ,2 0 8
2 ,9 8 6

I n t e r e s t p a y a b le
12 / 3 1/ 0 7

D e p r e c ia tio n e x p e n s e
A c c u m u la t e d D e p r e c i a t i o n

2 ,9 8 6
1 5 ,0 0 0
1 5 ,0 0 0

Lessor
Chapter Accounting for Residual Value
21-33 assumes that it will receive the residual value at the end of the lease
Lessor
term whether guaranteed or unguaranteed.

Lessor Accounting for Residual Value

LESSOR Four- year lease, $60K asset (cost & PV) with $5K
RV. Asset returns to lessor at end of lease. Lessor desires a
10% rate of return. Calculate lease payment.
R e s id u a l va lu e
P V o f s in g le s u m ( i= 1 0 % , n = 4 )

5 ,0 0 0
0 .6 8 3 0 1

P V o f r e s id u a l v a lu e

3 ,4 1 5

C o s t o f e q u ip m e n t to b e r e c o v e r e d

6 0 ,0 0 0

P r e s e n t v a lu e o f r e s id u a l v a lu e

(3 ,4 1 5 )

A m o u n t to b e r e c o v e r e d th r o u g h le a s e p a y m e n t
P V f a c to r o f a n n u n ity d u e (i= 1 0 % , n = 4 )
A n n u a l L e a s e p a y m e n t r e q u ir e d
Lessor
Chapter Calculation of Lease Payment
PV 21-35
= (Payment) (PV Factor, 10%, 4)
$56,585 = (Payment) (3.48685)
$56,585/3.48685 = $16,228

5 6 ,5 8 5

3 .4 8 6 8 5
$

1 6 ,2 2 8