ACCOUNTING FOR LEASE

LEASE
A lease agreement is a contract between two parties,
the lessor and the lessee. The lessor is the legal owner
of the asset, the lessee obtains the right to use the
asset in return for rental payments.
Leases are contracts in which the property/asset owner allows
another party to use the property/asset in exchange for
something, usually money or other assets. The two most
common types of leases in accounting are operating (rental)
lease and financing (capital lease) leases.
 Parties to Lease
1. Lessor
a. The financer for return
b. The purchaser of asset
c. The original owner
d. Can be a manufacturer or Dealer of a specific asset
e. Makes the initial arrangements of funds for the asset
2. Lessee
a. The borrower at some cost
b. The user of asset
c. May be a subsequent owner
d. The customer
e. May be paying a small amount at the start of contract (inception)
Types of Lease
1. Finance/Capital Lease:
A finance lease is a lease that transfers substantially all the risks and
rewards incidental to ownership of an asset to the lessee.
2. Operating/Rental Lease:
A lease is classified as an operating lease if it does not transfer
substantially all the risks and rewards incidental to ownership.
Risks may be represented by the possibility of losses from:
• idle capacity;
• technological obsolescence;
• variations in return caused by changes in economic
conditions.
Rewards may be represented by the expectation of;
• profitable use of the asset over its economic life;
• gains from increases in value or profits on disposal.
 Conditions when lease is a
Capital Lease
(a) the lease transfers ownership of the underlying asset to the lessee by
the end of the lease term;
(b) the underlying asset is of such a specialized nature that only the
lessee can use it without major modifications and the lease term is for
the major part of the economic life of the underlying asset even if title is
not transferred;
(c) at the inception date, the present value of the lease payments
amounts to at least substantially all of the fair value of the underlying
asset; and
(d) the lessee has the option to purchase the underlying asset at a price
that is expected to be sufficiently lower than the fair value at the date
the option becomes exercisable for it to be reasonably certain, at the
inception date, that the option will be exercised;
 Quick Test:
Capital VS Operating Lease
1st test – Does the title/ownership transfer to the lessee at the end of
the lease term?
2nd test – Is there a bargain purchase option?
3rd test – Is the lease term 75% or more of the remaining economic
life of the asset?
4th test – Does the present value of the sum of the lease payments
exceed 90% or more of the fair value of the underlying asset?
 Capital/Finance Lease
Let’s say that Company A (Lessor) enters into a capital lease contract
to lease Machinery with Company B (Lessee) on January 1, 2016. The
agreement is to lease the Machinery worth $14,275 for a period of 4
years. The Machinery’s useful life is 5 years. The contract specifies
that lease payment of Rs. 5,000 should be made to A by B at the end
of each year on December 31 every year. There is no salvage value at
the end of the lease period. The lessee will have an option to buy the
asset at the end of the lease period at a value less than the fair market
value. Also prepare the notes to financial statements that will be
accompanied by the financial statements of Lessor and Lessee for year
ending on December 31, 2016.
Capital/Finance Lease
Year Date Installment Interest Expense Decrease in Remaining
Payment =Remaining Unpaid Principle Unpaid
Balance*15% amount Balance

Jan. 1, 2016 14275

1 De. 31, 2016 5,000 (14,275*0.15)= 2,141 5000-2141 14275-2859

= 2859 = 11416

2 De. 31, 2017 5,000 (11,416*0.15)= 1,712 5000-1712 11416-3288

= 3288 = 8128

3 De. 31, 2018 5,000 (8128 *0.15) = 1219 5000- 1219 8128-3781
= 3781 = 4347

4 De. 31, 2019 5,000 5000-4347 = 653 4347 00

Capital/Finance Lease
Purchase of Machinery on Jan.1, 2016
Lessor:
Date Particulars Debit $ Credit $
Jan. 1, 2016 Lease Receivable 14,275
Cash 14,275

Lessee:
Date Particulars Debit $ Credit $
Jan. 1, 2016 Machinery 14,275
Lease Payable 14,275
 Capital/Finance Lease
Balance Sheet On January 1, 2016
Lessor:
Assets Amount $ Liabilities $ Owners’ Equity Amount $

Non-Current Assets:
Lease Receivable 14,275

Lessee:
Assets Amount $ Liabilities $ Owners’ Equity Amount $

Non-Current Assets: Liabilities:

Machinery 14,275 Lease Payable 14,275
 Payment of Installment 1 on Dec. 31, 2016
Lessor:
Date Particulars Debit $ Credit $
Dec. 31, 2016 Cash 5,000
Interest Revenue 2,141
Lease Receivable 2,859

Lessee:
Date Particulars Debit $ Credit $
Dec. 31, 2016 Interest Expense/ Finance Cost 2,141
Lease Payable 2,859
Cash 5,000

Date Particulars Debit $ Credit $

Dec. 31, 2016 Depreciation Expense* 2,855
Accumulated Depreciation 2,855

*Depreciation Expense= (Cost-Residual Value)/Estimated Life= (14275-0)/5 = $ 2,855

 Capital/Finance Lease
Income Statement for the Year Ending On December 31, 2016
Lessor:
Amount $

Revenues:
Interest Revenue 2,141

Lessee:
Amount $

Expenses:
Interest Expense 2,141
Depreciation Expense 2,855
 Capital/Finance Lease
Balance Sheet On December 31, 2016
Lessor:
Assets Amount $ Liabilities $ Owners’ Equity Amount $

Non-Current Assets:
Lease Receivable 11,416

Lessee:
Assets Amount $ Liabilities $ Owners’ Equity Amount $

Non-Current Assets: Liabilities:

Machinery 14,275 Lease Payable 11,416
Less:
Accumulated Depreciation 2855 11,420
 Payment of Installment 2 on Dec. 31, 2017
Lessor:
Date Particulars Debit $ Credit $
Dec. 31, 2017 Cash 5,000
Interest Revenue 1,712
Lease Receivable 3,288

Lessee:
Date Particulars Debit $ Credit $
Dec. 31, 2017 Interest Expense/ Finance Cost 1,712
Lease Payable 3,288
Cash 5,000

Date Particulars Debit $ Credit $

Dec. 31, 2017 Depreciation Expense* 2,855
Accumulated Depreciation 2,855

*Depreciation Expense= (Cost-Residual Value)/Estimated Life= (14275-0)/5 = $ 2,855

 Capital/Finance Lease
Income Statement for the Year Ending On December 31, 2017
Lessor:
Amount $

Revenues:
Interest Revenue 1,712

Lessee:
Amount $

Expenses:
Interest Expense 1,712
Depreciation Expense 2,855
 Capital/Finance Lease
Balance Sheet On December 31, 2017
Lessor:
Assets Amount $ Liabilities $ Owners’ Equity Amount $

Non-Current Assets:
Lease Receivable 8,128

Lessee:
Assets Amount $ Liabilities $ Owners’ Equity Amount $

Non-Current Assets: Liabilities:

Machinery 14,275 Lease Payable 8,128
Less:
Accumulated Depreciation 5,710 8,565
 Capital/Finance Lease
Rentals in arrears treatment (Split year time period for installments)
On April 1, 2016 Allied Bank and Bush Co. entered into an agreement
to lease Machinery that had an estimated life of five years. The lease
period is four years, after which the ownership of asset will be
transferred to the lessee. Annual rentals of $5,000 are payable in
arrears from March 31, 2017. The Machinery is expected to have a nil
residual value at the end of its life. The Machinery had a fair value of
$14,275 at the inception of the lease. The lessor includes a finance
cost (interest rate) of 15% per annum when calculating annual rentals.
How should the lease be accounted for in the financial statements of
Allied Bank and Bush for the year end 31 December, 2016 and the
payment of lease installment on Merch 31, 2017. Also prepare the
notes to financial statements that will be accompanied by the financial
statements of Lessor and Lessee for year ending on December 31,
2016.
 Capital/Finance Lease
Purchase of Machinery on Apr.1, 2016
Lessor:
Date Particulars Debit $ Credit $
Apr. 1, 2016 Lease Receivable 14,275
Cash 14,275

Lessee:
Date Particulars Debit $ Credit $
Apr. 1, 2016 Machinery 14,275
Lease Payable 14,275
 Capital/Finance Lease
Balance Sheet On April 1, 2016
Lessor:
Assets Amount $ Liabilities $ Owners’ Equity Amount $

Non-Current Assets:
Lease Receivable 14,275

Lessee:
Assets Amount $ Liabilities $ Owners’ Equity Amount $

Non-Current Assets: Liabilities:

Machinery 14,275 Lease Payable 14,275
 Closing of books on Dec. 31, 2016
Lessor:
Date Particulars Debit $ Credit $
Dec. 31, 2016 Interest Revenue Receivable 1,606
Interest Revenue (14275*.15)*9/12 1,606

Lessee:
Date Particulars Debit $ Credit $
Dec. 31, 2016 Interest Expense/ Finance Cost 1,606
Interest Payable 1,606

Date Particulars Debit $ Credit $

Dec. 31, 2016 Depreciation Expense* 2,141
Accumulated Depreciation 2,141

*Depreciation Expense= (Cost-Residual Value)/Estimated Life= (14275-0)/5 = $ 2,855

2,855*9/12 = $ 2,141
 Capital/Finance Lease
Income Statement for the Year Ending On December 31, 2016
Lessor:
Amount $

Revenues:
Interest Revenue 1,606

Lessee:
Amount $

Expenses:
Interest Expense 1,606
Depreciation Expense 2,141
 Capital/Finance Lease
Balance Sheet On December 31, 2016
Lessor:
Assets Amount $ Liabilities $ Owners’ Equity Amount $

Non-Current Assets:
Lease Receivable 14,275
Current Assets:
Interest Revenue Receivable 1,606

Lessee:

Assets Amount $ Liabilities $ Owners’ Equity Amount $

Non-Current Assets: Non-Current Liabilities:

Machinery 14,275 Lease Payable 14275
Less: Current Liabilities:
Accumulated Depreciation 2,141 12,151 Interest payable 1,606
 Payment of Installment 1 on March 31, 2017
Lessor:
Date Particulars Debit $ Credit $
Mar. 31, 2017 Cash 5,000
Interest Revenue (14,275*.15)*3/12 535
Lease Receivable 2,859
Interest Receivable 1,606

Lessee:
Date Particulars Debit $ Credit $
Mar. 31, 2017 Interest Expense/ Finance Cost 535
Lease Payable 2,859
Interest Payable 1,606
Cash 5,000
 Closing of books on Dec. 31, 2017
Lessor:
Date Particulars Debit $ Credit $
Dec. 31, 2017 Interest Revenue Receivable 1,284
Interest Revenue (11,416*.15)*9/12 1,284

Lessee:
Date Particulars Debit $ Credit $
Dec. 31, 2017 Interest Expense/ Finance Cost 1,284
Interest Payable 1,284

Date Particulars Debit $ Credit $

Dec. 31, 2017 Depreciation Expense* 2,855
Accumulated Depreciation 2,855

*Depreciation Expense= (Cost-Residual Value)/Estimated Life= (14275-0)/5 = $ 2,855

 Capital/Finance Lease
Income Statement for the Year Ending On December 31, 2017
Lessor:
Amount $

Revenues:
Interest Revenue 1,284

Lessee:
Amount $

Expenses:
Interest Expense 1,284
Depreciation Expense 2,855
 Capital/Finance Lease
Balance Sheet On December 31, 2017
Lessor:
Assets Amount $ Liabilities $ Owners’ Equity Amount $

Non-Current Assets:
Lease Receivable 11,416
Current Assets:
Interest Revenue Receivable 1,284

Lessee:

Assets Amount $ Liabilities $ Owners’ Equity Amount $

Non-Current Assets: Non-Current Liabilities:

Machinery 14,275 Lease Payable 11,416
Less: Current Liabilities:
Accumulated Depreciation 4,996 9,279 Interest payable 1,284
(2,141+2,855)
 Payment of Installment 2 on March 31, 2018
Lessor:
Date Particulars Debit $ Credit $
Mar. 31, 2018 Cash 5,000
Interest Revenue (14,275*.15)*3/12 428
Lease Receivable 3,288
Interest Receivable 1,284

Lessee:
Date Particulars Debit $ Credit $
Mar. 31, 2018 Interest Expense/ Finance Cost 428
Lease Payable 3,288
Interest Payable 1,284
Cash 5,000
 Operating/Rental Lease
Rentals in arrears treatment
On January 1, 2016 Allied Bank and Bush Co. entered into an
agreement to lease a machine that had an estimated life of eight
years. The lease period is four years, at which point the machine will
be returned to the lessor (Bank) and ownership of asset will be
retained by the bank. Annual rentals of $2,500 are payable in arrears
from December 31, 2016. The machine is expected to have a nil
residual value at the end of its life. The machine had a fair value of
$14,275 at the inception of the lease.
How should the lease be accounted for in the financial statements of
Allied Bank and Bush for the year end December 31, 2016 and Dec. 31,
2017. Also prepare the notes to financial statements that will be
accompanied by the financial statements of Bush for year ending on
December 31, 2016.
 Operating/Rental Lease
Purchase of Machinery on Jan.1, 2016
Lessor:

Date Particulars Debit $ Credit $

Jan. 1, 2016 Machinery 14,275
Cash 14,275

Lessee:
Date Particulars Debit $ Credit $
Jan. 1, 2016 No entry shall be recorded
 Operating/Rental Lease
Balance Sheet On January 1, 2016
Lessor:
Assets Amount $ Liabilities $ Owners’ Equity Amount $

Non-Current Assets:
Machinery 14,275

Lessee:
Assets Amount $ Liabilities $ Owners’ Equity Amount $
 Payment of First year Rental on Dec. 31, 2016
Lessor:
Date Particulars Debit $ Credit $
Dec. 31, 2016 Cash 2,500
Rental Revenue 2,500

Date Particulars Debit $ Credit $

Dec. 31, 2016 Depreciation Expense* 1,785
Accumulated Depreciation 1,785

*Depreciation Expense= (Cost-Residual Value)/Estimated Life= (14275-0)/8 = $ 1,785

Lessee:

Date Particulars Debit $ Credit $

Dec. 31, 2016 Rental Expense 2,500
Cash 2,500
 Operating/Rental Lease
Income Statement for the Year Ending On December 31, 2016
Lessor:
Amount $

Revenues:
Rental Revenue 2,500
Expenses:
Depreciation Expense 1,785

Lessee:
Amount $

Expenses:
Rental Expense 2,500
 Operating/Rental Lease
Balance Sheet On December 31, 2016
Lessor:
Assets Amount $ Liabilities $ Owners’ Equity Amount $

Non-Current Assets:
Machinery 14,275
Less:
Accumulated Depreciation 1,785 12,490

Lessee:
Assets Amount $ Liabilities $ Owners’ Equity Amount $
 Payment of Second year Rental on Dec. 31, 2017
Lessor:
Date Particulars Debit $ Credit $
Dec. 31, 2017 Cash 2,500
Rental Revenue 2,500

Date Particulars Debit $ Credit $

Dec. 31, 2017 Depreciation Expense* 1,785
Accumulated Depreciation 1,785

*Depreciation Expense= (Cost-Residual Value)/Estimated Life= (14275-0)/8 = $ 1,785

Lessee:

Date Particulars Debit $ Credit $

Dec. 31, 2017 Rental Expense 2,500
Cash 2,500
 Operating/Rental Lease
Income Statement for the Year Ending On December 31, 2017
Lessor:
Amount $

Revenues:
Rental Revenue 2,500
Expenses:
Depreciation Expense 1,785

Lessee:
Assets Amount $

Expenses:
Rental Expense 2,500
 Operating/Rental Lease
Balance Sheet On December 31, 2017
Lessor:
Assets Amount $ Liabilities $ Owners’ Equity Amount $

Non-Current Assets:
Machinery 14,275
Less:
Accumulated Depreciation 3,570 10,705

Lessee:
Assets Amount $ Liabilities $ Owners’ Equity Amount $
 Operating/Rental Lease
Rentals in arrears treatment: Split year treatment
On July 1, 2016 Allied Bank and Bush Co. entered into an agreement to
lease a machine that had an estimated life of eight years. The lease
period is four years, at which point the machine will be returned to
the lessor (Bank) and ownership of asset will be retained by the bank.
Annual rentals of $2,500 are payable in arrears from 30 June, 2017.
The machine is expected to have a nil residual value at the end of its
life. The machine had a fair value of $14,275 at the inception of the
lease.
How should the lease be accounted for in the financial statements of
Allied Bank and Bush for the year end December 31, 2016 and June
30, 2017. Also prepare the notes to financial statements that will be
accompanied by the financial statements of Bush for year ending on
December 31, 2016.
 Operating/Rental Lease
Purchase of Machinery on July 1, 2016
Lessor:
Date Particulars Debit $ Credit $
Jul. 1, 2016 Machinery 14,275
Cash 14,275

Lessee:

Date Particulars Debit $ Credit $

Jul. 1, 2016 No entry shall be recorded
 Operating/Rental Lease
Balance Sheet On July 1, 2016
Lessor:
Assets Amount $ Liabilities $ Owners’ Equity Amount $

Non-Current Assets:
Machinery 14,275

Lessee:
Assets Amount $ Liabilities $ Owners’ Equity Amount $
 Closing of First year on Dec. 31, 2016
Lessor:
Date Particulars Debit $ Credit $
Dec. 31, 2016 Rental Receivable 1,250
Rental Revenue 1,250

Date Particulars Debit $ Credit $

Dec. 31, 2016 Depreciation Expense* 893
Accumulated Depreciation 893

*Depreciation Expense= (Cost-Residual Value)/Estimated Life= (14275-0)/8 = $ 1,785

(1,785)*6/12= 892=893
Lessee:

Date Particulars Debit $ Credit $

Dec. 31, 2016 Rental Expense 1,250
Rental Payable 1,250
 Operating/Rental Lease
Income Statement for the Year Ending On December 31, 2016
Lessor:
Amount $

Revenues:
Rental Revenue 1,250
Expenses:
Depreciation Expense 893

Lessee:
Amount $

Expenses:
Rental Expense 1,250
 Operating/Rental Lease
Balance Sheet On December 31, 2016
Lessor:
Assets Amount $ Liabilities $ Owners’ Equity Amount $
Current Assets:
Rentals Receivable 1,250

Non-Current Assets:
Machinery 14,275
Less:
Accumulated Depreciation 893 13,382
Lessee:
Assets Amount $ Liabilities $ Owners’ Equity Amount $

Current Liabilities:
Rentals Payable 1,250
 Payment of First year Rental on June 30, 2017
Lessor:
Date Particulars Debit $ Credit $
Jun. 30, 2017 Cash 2,500
Rental Revenue 1,250
Rental Receivable 1,250

Lessee:

Date Particulars Debit $ Credit $

Jun. 30, 2017 Rental Expense 1,250
Rental Payable 1,250
Cash 2,500
 Operating/Rental Lease
Income Statement for the half Year Ending On June 30, 2017
Lessor:
Amount $

Revenues:
Rental Revenue 1,250

Lessee:
Amount $

Expenses:
Rental Expense 1,250
 Operating/Rental Lease
Balance Sheet On June 30, 2017
Lessor:
Assets Amount $ Liabilities $ Owners’ Equity Amount $

Non-Current Assets:
Machinery 14,275
Less:
Accumulated Depreciation 893 13,382

Lessee:
Assets Amount $ Liabilities $ Owners’ Equity Amount $
 Operating/Rental Lease
Rentals in advance treatment
On January 1, 2016 Allied Bank and Bush Co. entered into an
agreement to lease a machine that had an estimated life of eight
years. The lease period is four years, at which point the machine will
be returned to the lessor (Bank) and ownership of asset will be
retained by the bank. Annual rentals of $2,500 are payable in advance
from January 1, 2016. The machine is expected to have a nil residual
value at the end of its life. The machine had a fair value of $14,275 at
the inception of the lease.
How should the lease be accounted for in the financial statements of
Allied Bank and Bush for the dates January 1, 2016 and year end
December 31, 2016. Also prepare the notes to financial statements
that will be accompanied by the financial statements of Bush for year
ending on December 31, 2016.
 Purchase of Machinery on Jan.1, 2016
Lessor:
Date Particulars Debit $ Credit $
Jan. 1, 2016 Machinery 14,275
Cash 14,275

Date Particulars Debit $ Credit $

Jan. 1, 2016 Cash 2,500
Unearned Rental Revenue 2,500

Lessee:

Date Particulars Debit $ Credit $

Jan. 1, 2016 Prepaid Rental 2,500
Cash 2,500
 Operating/Rental Lease
Balance Sheet On Jan 1, 2016
Lessor:
Assets Amount $ Liabilities $ Owners’ Equity Amount $

Non-Current Assets: Current Liabilities:

Machinery 14,275 Unearned Rental Revenue 2,500

Lessee:
Assets Amount $ Liabilities $ Owners’ Equity Amount $

Current Assets:
Prepaid Rental Expense 2,500
 Closing of First year on Dec. 31, 2016
Lessor:
Date Particulars Debit $ Credit $
Dec. 31, 2016 Unearned Rental Revenue 2,500
Rental Revenue 2,500

Date Particulars Debit $ Credit $

Dec. 31, 2016 Depreciation Expense* 1,785
Accumulated Depreciation 1,785

*Depreciation Expense= (Cost-Residual Value)/Estimated Life= (14275-0)/8 = $ 1,785

Lessee:

Date Particulars Debit $ Credit $

Dec. 31, 2016 Rental Expense 2,500
Prepaid Rental Expense 2,500
 Operating/Rental Lease
Income Statement for the Year Ending On December 31, 2016
Lessor:
Amount $

Revenues:
Rental Revenue 2,500
Expenses:
Depreciation Expense 1,785

Lessee:
Amount $

Expenses:
Rental Expense 2,500
 Operating/Rental Lease
Balance Sheet On December 31, 2016
Lessor:
Assets Amount $ Liabilities $ Owners’ Equity Amount $
Non-Current Assets:
Machinery 14,275
Less:
Accumulated Depreciation 1785 12,490

Lessee:
Assets Amount $ Liabilities $ Owners’ Equity Amount $