CHAPTER 21

Accounting for Leases

LEARNING OBJECTIVES

1. Describe the environment related to leasing standards.

2. Explain the accountinf for leases by lessees.
3. Explain the accountinf for leases by lessors.
4. Discuss the accounting and reporting for special features of lease arrangements.
*5. Describe the lessee’s accounting for sale-leaseback transactions.
*6. Apply lessee and lessor accounting to finance and operating leases.

*This material is covered in an Appendix to the Chapter.

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CHAPTER REVIEW
1. Many businesses lease substantial portions of the property and equipment they use in their
business organization as an alternative to ownership. Because leasing provides some
financial, operating, and risk advantages over ownership, it has become the fastest growing
form of capital investment. This increased significance of lease arrangements in recent
years has intensified the need for uniform accounting and complete informative reporting of
leasing transactions. Chapter 21 presents a discussion of the accounting issues related to
leasing arrangements from the point of view of both the lessee and the lessor. Among
the issues discussed are: (1) the classification of leasing arrangements, (2) the various
methods used in accounting for leases, and (3) the financial statement disclosure requirements
when leases are present.

The Leasing Environment

2. (L.O. 1) 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.
In return for this right, the lessee agrees to make rental payments over the lease term to
the lessor. The major types of companies who serve as lessors are banks, captive leasing
companies (subsidiaries of manufacturers), and independents.

Advantages of Leasing

3. In discussing the advantages of leasing arrangements, advocates point out that leasing allows
for: (a) 100% financing at fixed rates, (b) protection against obsolescence, (c) flexibility,
and (d) less costly financing for lessees. Advantages to lessors include (a) profitable
interest margins, (b) higher sales, and (c) tax benefits.

4. A variety of opinions exist regarding the manner in which certain long-term lease arrange-
ments should be accounted for. These opinions range from capitalization of all long-term
leases to the belief that leases represent executory contracts that should not be
capitalized. The IASB agrees with an approach that calls for capitalization of leasing
transactions as the right to use property under the terms of a lease is an asset and the
obligation to make payments under the lease is a liability. The IASB requires that all leases
be capitalized unless the lease is for less than one year or the asset is worth less than
$5,000.

Accounting by the Lessee

5. (L.O. 2) The finance lease method is used to account for the lease. The lease liability is
computed as the present value of the lease payments.The lessee recognizes interest
expense on the lease liability over the lease term and records depreciation expense on the
right-of-use asset.

6. The lease term is the fixed, non-cancelable term of the lease and may be extened by a.
bargain renewal option, a provision allowing the lessee to purchase the leased property
for a price that is significantly lower than the property’s expected fair value at the date the
option becomes exercisable.

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Finance Leases for Lessees

7. Under the finance lease method the lessee treats the lease transaction as if an asset
were being purchased over time (installment basis). For a finance lease, the lessee records
an asset and a liability at the lower of (a) the present value of the minimum lease payments
during the term of the lease or (b) the fair market value of the leased asset at the inception
of the lease. In determining the present value of the minimum lease payments, three
important concepts are involved: (a) minimum lease payments, (b) executory costs, and
(c) the discount rate.

8. Minimum lease payments include (a) minimum rental payments, (b) any guaranteed
residual value, (c) penalty for failure to renew or extend the lease, and (d) any bargain
purchase option. Minimum rental payments are the minimum payments the lessee is
obligated to make to the lessor under the lease agreement. A guaranteed residual value is
the estimated fair (market) value of the leased property at the end of the lease term. This
allows the lessor to transfer the risk of loss in the fair value of the asset to the lessee. The
guaranteed residual value is (a) the certain or determinable amount at which the lessor
has the right to require the lessee to purchase the asset or (b) the amount the lessee or
the third-party guarantor guarantees the lessor will realize.

9. Executory costs include the cost of insurance, maintenance, and tax expense related to
the leased asset. If the lessor makes these payments, such amounts should reduce the
present value of the minimum lease payments. When the lease agreement specifies that
executory costs are assumed by the lessee, the rental payments can be used without
adjustment in the present value computation. The lessee uses the implicit rate to compute
the present value of the minimum lease payments. This rate is defined as the discount
rate that, at the inception of the lease, causes the aggregate present value of the
minimum lease payments and the unguaranteed residual value to be equal to the fair
value of the leased asset. In the event the implicit rate cannot be determined, the lessee
uses its incremental borrowing rate.

10. Each lease payment is allocated between a reduction of the lease obligation and interest
expense applying the effective interest method. The lessee should depreciate the leased
asset by applying one of the conventional depreciation methods. The depreciation period
is the economic life of the asset if the lease meets either the transfer of ownership
(criterion 1) or has a bargain-purchase option (criterion 2); otherwise the depreciation
period is the lease term. During the term of the lease, leased assets are separately
identified in the lessee’s statement of financial position. Likewise, the related obligations are
separately identified with the portion due within one year or the operating cycle, whichever is
longer, classified with current liabilities and the balance with noncurrent liabilities.

11. A complete illustration of the accounting for a finance lease by the lessee is found in the
text. It is important to understand the preparation of the Lease Amortization Schedule.
This schedule provides the basis for the entire range of journal entries for the lease
transaction. The basic entries include: (a) initial capitalization which requires a debit to the
asset and a credit to the liability, (b) annual lease payments which include a debit to the
liability and a credit to cash, and (c) the annual depreciation entry. Of course, any interest
accrual or executory costs would be included in the entries made for the lease obligation.

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Accounting by the Lessor

12. (L.O. 3) For lessor accounting purposes, all leases may be classified as either operating
or finance leases. Finance leases are further subdivided into: (a) direct financing
leases, or (b) sales-type leases. To determine whether a lease is an operating lease or a
finance lease, the lessor uses the following criteria:

a. Does the lease transfer ownership of the asset to the lessee at the end of the lease
term?
b. Does the lease grant the lessee and option to buy the asset that the lessee is
reasonably certain to exercise?
c. Is the lease term for a major part of the remaining economic life of the asset?
d. Does the present value of the sum of the lease payments any guanteed residual
value equal or exceed substantially all of the asset’s fair value?
e. Is the asset of such a specialized nature that it is expected to have no alternative
use to the lessor at the end of the lease term?
Leases that meet one of more of these criteria are classified as finance leases.

13. The distinction between a direct financing lease and a sales-type lease is that a sales-
type lease involves manufacturer’s or dealer’s profit (or loss) and a direct financing
lease does not. The primary difference between applying the financing method to a direct
financing lease and applying it to a sales-type lease is the recognition of the manufacturer’s
or dealer’s profit at the inception of the lease. The profit or loss to the lessor is evidenced
by the difference between the fair value of the leased property at the inception of the
lease and the lessor’s cost or carrying amount (book value). All leases that do not qualify
as direct financing or sales-type leases are classified and accounted for by the lessors as
operating leases.

Finance Lease (Lessor)

14. The lessor records increases to sales, cost of goods sold and a lease receivable, and a
decrease to inventory. The lease receivable is the present value of the minimum lease
payments. The “minimum lease payments” include:
a. rental payments (excluding executory costs),
b. bargain purchase option (if any),
c. guaranteed residual value (if any), and
d. penalty for failure to renew (if any).

15. Interest revenue is recognized over the lease term as lease receipts are split between
interest revenue and reduction of the lease receivable using the effective interest method.

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Residual Value

16. The residual value of a leased asset is the estimated fair value of the asset at the end of
the lease term. The residual value may be guaranteed or unguaranteed by the lessee. A
guaranteed residual value is said to exist when the lessee agrees to make up any
deficiency below a stated amount in the value of the asset at the end of the lease term.
A guaranteed residual value affects the lessee’s computation of the minimum lease
payments and, therefore, the amounts capitalized as a leased asset and a lease obligation.
The lessor assumes the residual value will be realized at the end of the lease term whether
guaranteed or unguaranteed.

17. To understand the accounting implications of a guaranteed residual value, assume a lessee
guarantees the residual value of an asset will be €8,000. If, at the end of the lease, the
fair market value of the residual value is less than €8,000, the lessee will have to record
a loss for the difference. For example, if the lessee depreciated the asset down to its
residual value of €8,000 but the fair market value of the residual value was €4,000, the
lessee would have to record a loss of €4,000 and pay the lessor €4,000. If the fair market
value of the asset exceeds the €8,000, a gain may be recognized. Gains on guaranteed
residual values may be apportioned to the lessor and lessee in whatever ratio the parties
initially agree. From the perspective of the lessee, if there is an unguaranteed residual
value, it as the same as no residual value. From the perspective of the lessor, once the
payments are established, it makes no difference from an accounting point of view whether
the residual value is guaranteed or unguaranteed.

18. Under sales-type leases, the profit recorded by the lessor at the point of sale is the same
whether the residual value is guaranteed or unguaranteed, but the sales revenue and cost
of goods sold amounts are different. Due to the uncertainty surrounding the realization of
the unguaranteed residual value, the present value of the unguaranteed residual value is
deducted from sales revenue and cost of goods sold. However, the gross profit is the same
whether a guaranteed or unguaranteed residual value is involved.

Operating Leases (Lessor)

19. Under an operating lease, the asset remains on the lessor’s books. Lease revenue is
generally recognized on a straight-line basis. The asset is depreciated over its economic
life.

Special Accounting Problems

20. (L.O. 4) Leases have certain characteristics that create unique accounting problems. The
next paragraphs review these characteristics.

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21. Other lease adjustments include executory costs, lease prepayments and incentives and
initial direct costs. The accounting for executory costs, such as property tax and
insurance, depends on the structure of the lease, specifically whether it is a gross lease
or a net lease. Lease Prepayments and Incentives may result in changes to the amount
reported for the leased asset.

Initial Direct Costs

22. Initial direct costs are the costs incurred by the lessor that are directly associated with
negotiating and consummating a completed leasing transaction. There are two types of
initial direct costs, incremental direct costs and internal direct costs. Incremental direct
costs are costs incurred in originating a lease arrangement that are paid to third parties.
Internal direct costs are costs directly related to specified activities performed by the
lessor on a given lease. When an operating lease is present, the initial direct costs are
deferred and amortized over the life of the lease in proportion to rental income. In a sales-
type lease, these costs are expensed in the period that profit on the sale is recognized.
For direct financing leases, initial direct costs are added to the net investment in the lease
and amortized over the life of the lease as a yield adjustment.

Bargain Purchase Options

23. A bargain purchase option is a provision allowing the lessee, at his or her option, to
purchase the leased property at a price that is substantially lower than the expected fair
value of the property at the date the option becomes exercisable. When a bargain
purchase option exists, the lessee must increase the present value of the minimum lease
payments by the present value of the option price. The only difference between accounting
for a bargain purchase option and a guaranteed residual value of identical amounts is in the
computation of the annual depreciation. In the case of a guaranteed residual value, the
lessee depreciates the asset over the lease life. When a bargain purchase option is
present, the lessee uses the economic life of the asset in computing depreciation.

Current versus Non-Current

24. Lease liabilities should be classified into current and non-current amounts. A common
method of measuring the current portion of the lease liability is the change-in-the-present-
value method. Using this method, the current portion is the reduction in principal for the
next period (from the lease amortization schedule).

Disclosure

25. The IASB requires that specific information with respect to operating leases and finance
leases be disclosed in the lessee's financial statements, including the following:

For lessees:

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 • A general description of material leasing arrangements.
• A reconciliation between the total of future minimum lease payments at the end of the
reporting period and their present value.
• The total of future minimum lease payments at the end of the reporting period, and
their present value for periods (1) not later than one year, (2) later than one year and
not later than five years, and (3) later than five years.

For lessors:

• A general description of material leasing arrangements.

• A reconciliation between the gross investment in the lease at the end of the reporting
period, and the present value of minimum lease payments receivable at the end of the
reporting period.
• Unearned finance income.
• The gross investment in the lease and the present value of minimum lease payments
receivable at the end of the reporting period for periods (1) not later than one year,
(2) later than one year and not later than five years, and (3) later than five years.

*Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.

*Sale-Leaseback

26. (L.O. 5) A “sale-leaseback” transaction is one in which the owner of property sells it to
another and simultaneously leases it back from the new owner. The seller-lessee, in a sale-
leaseback transaction, should apply the same criteria mentioned earlier in deciding whether
to account for the lease as a finance lease or an operating lease. Likewise, the purchaser-
lessor should also apply the criteria mentioned earlier in deciding whether the sale-
leaseback transaction should be accounted for using the operating method or the financing
method.

27. (L.O. 6) Comprehensive Example of Lease Arrangements

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LECTURE OUTLINE
The material in this chapter can be covered in four class periods. Students generally are unfamiliar
with lease terminology; therefore, it might be beneficial to discuss concepts and terminology
before demonstrating the technical aspects of recording leases. Illustrations 21-5 through
21-14 demonstrate the lease accounting entries made by both the lessee and lessor and they
are all based on the same example data.

A. (L.O. 1) Leases.

1. Definition: Contractual agreement between a lessor and a lessee that conveys to the

lessee the right to use specific property owned by the lessor for a specified period of
time.

2. Advantages of leasing:  Conservation of cash, flexibility, protection against

obsolescence, less costly financing, financing.

3. Provisions of leases: For example, duration, rental payments, executory costs,

cancelability, restrictions, and alternatives of the lessee at termination.

4. Basic premise of lease accounting:  The right to use property under the terms of a
lease is an asset and the obligation to make payments under the lease is a liability.

B. (L.O. 2) Lessees.

1. The IASB requires that all leases be capitalized unless the lease is for less than one year
or the asset is worth less than $5,000.

2. The leased asset and the lease liability are recorded on the books of the lessor.

3. Finance Lease Method: Asset and liability recorded at PV of the minimum lease

payments.

a. Computation of minimum lease payments. Include the minimum rental payments,

guaranteed residual value, penalty for failure to renew or extend the lease, and
bargain purchase option.

b. Residual value: The estimated fair value of the property at the end of the lease term.

c. Discount rate: The implicit rate is used (unless it is unknown, then the

incremental rate is used).

d. Executory costs: Insurance, maintenance, and tax expenses. Excluded from the

present value of the minimum lease payments.

e. Effective interest method:  Allocates each lease payment between reduction of

the lease liability principal and interest expense.

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D. (L.O. 3) Lessors.

1. Benefits.

a. Interest revenue.

b. Tax incentives.

c. High residual value.

2. Classification by the lessor

a. Operating Leases.

b. Finance Leases. Noncancelable and meet at least one of five tests.

3. Operating Method.  Rental revenue recognized as lessee uses property.

4. Finance Leases are classified as either Direct Financing Leases or Sales-Type

Leases.

a. Direct Financing Leases. Lease receivable is equal to the present value of the
minimum lease payments. Use the effective interest method to allocate each lease
payment to interest revenue and principal.

b. Sales-type Leases. Information necessary to record a sales-type lease includes:

(1) Sales Price: Present value of the minimum lease payments.

(2) Cost of Goods Sold: Cost of the asset to the lessor.

Manufacturer’s or dealer’s gross profit. The difference between sales price and

cost of goods sold.

(1) Is the same whether a guaranteed or unguaranteed residual value is involved.

(a) Guaranteed residual considered part of sales revenue.

(b) The present value of the unguaranteed residual value is deducted from
sales revenue and cost of goods sold.

(2) However, sales and cost of goods sold will differ.

(3) The estimated unguaranteed residual value must be reviewed periodically.

E. (L.O. 4) Special Accounting Problems.

1. Residual Values.

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 a. Unguaranteed versus guaranteed residual values.

b. Reasons for guaranteed residual values.

(1) Protects lessor against any loss of estimated residual value.

(2) Included in minimum lease payments.

c. Impact on lessee of guaranteed residual values—computation of minimum lease

payments, capitalized amount of the leased asset and related obligation.

2. Initial Direct Costs: Costs incurred by the lessor associated with negotiating,

consummating, and processing the lease.

a. Operating leases: Defer such costs and allocate them over the lease term in
proportion to the recognition of rental income.

b. Sales-type leases: Expensed in the period when incurred when the profit on sale
is recognized.

c. Direct financing lease: The costs are first added to the net investment and then
amortized over the life of the lease as a yield adjustment.

3. Bargain Purchase Options:  Allows the lessee to purchase the leased property for
a future price that is much lower than the expected future fair value of the property.

The lessee must increase the present value of the minimum lease payments by the
present value of the option price. Lessee uses the economic life of the asset when
computing depreciation.

Disclosure

4. Disclosure.

a. Disclosures for lessees.

b. Disclosures for lessors.

F. (L.O. 5) Appendix 21-A. Sale-Leasebacks.

Sale-leaseback Transactions: The owner of property sells it to another and simultaneously

leases it back from the new owner.

1. Any gain should be deferred and amortized over the lease term if the seller-lessee
retains substantially all of the rights to use the property. Losses are recognized

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 immediately.

2. The classification of the lease as an operating or a finance lease is done by the same
criteria as discussed earlier.

G. (L.O. 6) Appendix 21-A. Comprehensive Example of Lease Arrangements

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