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Intermediate

Financial Accounting

Accounting for Leases


Objectives of the Chapter
1. Understand the Environment of leasing
transactions.
2. Explain the accounting for operating leases.
3. Discuss the accounting for capital leases (or
financial lease under ASU2016-2).
 For lessees - with or without guaranteed residual value
and bargain purchase option and.
 For lessors - Direct financing and sales type.
4. Discuss the accounting and reporting for special
features in lease arrangements.
5. Discuss ASU2016-2 Accounting for Leases 2
Environment of leasing transactions

 According to FASB statement No. 13


(FASB ASC 840), a lease is defined as
“an agreement conveying the right to use
property, plant, or equipment for a stated
period of time”.

 A lease involves a lessee and a lessor.

 A lessee acquires the right to use the


property, plant and equipment and a
lessor gives up theAccounting
right. for Leases 3
Environment of leasing transactions
(contd.)
 A lease is a contractual agreement and
therefore the parties involved can
incorporate any provision in the contract. All
kinds of assets can be leased.
 Among the most popular are equipment,
commercial vehicles, computers, copiers,
airplanes, and warehouses.

Accounting for Leases 4


Lessors (source: Kieso, Weygandt, and Warfield )
 Lessors who own the property include:
 Banks: The largest lessors in the leasing
industry. They provide general finance for
companies. Examples: Wells Fargo, Chase, Citigroup.
 Captive leasing companies: subsidiaries
whose primary business is to perform
leasing operations for the parent company
(i.e., structure lease contracts for the parent
companies and their customers). Examples:
Chrysler Capital (for Fiat-Chrysler Automobiles), IBM Global Financing
(for IBM), Ford Motor Credit (for Ford) and Boeing Capital (for Boeing).
Accounting for Leases 5
Lessors (contd.)
 Independents: leasing companies whose
primary business is to perform general
finance for other companies.
 Their market share of leasing business has
declined as the other two types of lessor’s
market share has increased. According to Equipment
Leases and Finance Foundation 2015 annual report, banks hold about 55% of
new business in leases, followed by 31% of captive and 14% of independents.

 Some independent lessors have become the


captive finance companies for other
companies without a leasing subsidiary.
Accounting for Leases 6
Lease Market
 The Equipment Leasing Associate (ELA)
states that the global equipment-lease
market is a $900 billion business with the
U.S. accounting for about one third of the
global market (source: Kieso, Weygandt and Warfield
textbook).
 ELA also estimated 63% ($946 billion) of the
$1.5 trillion total fixed investment expected in
domestic business is financed by leases
(source: Kieso, Weygandt and Warfield textbook).

Accounting for Leases 7


Leased Assets
 This chapter emphasizes the long-term
non-cancelable leases involving
depreciable personal property such as
equipment, computers, machinery,
airplanes, and other movable assets.

Accounting for Leases 8


Advantages of Leasing from Lessees'
Viewpoint (source: Kieso and Weygandt)
1. Financing Benefits
a. The lease provides 100% financing (no
down payment is needed). For
companies with cash shortage, lease
is a good alternative to purchase;
b. The lease contract may contain fewer
restrictive provisions than other debt
agreement; and
c. The lease agreement creates a claim
that is against only the leased asset ,
not against all assets.

Accounting for Leases 9


Advantages of Leasing from
Lessees' Viewpoint :(contd.)
2. Risk benefit:
Reduce the risk of obsolescence.
3. Flexibility:
The lessor may tailor the lease agreement
to meet the needs of the lessess.

Accounting for Leases 10


Advantages of Leasing from
Lessees' Viewpoint :(contd.)
4. Tax advantage:
Tax deduction may be accelerated since it is
often spread over the lease term rather than
the economic life of the property).The full cost
of the leased asset can be written off including
the part that relates to land.
(eliminated by ASU2016-2)Using operating
leases for financial reporting while capital
leases for tax purposes to claim depreciation
for tax purposes. (skip)

Accounting for Leases 11


Advantages of Leasing from
Lessees' Viewpoint :(contd.)
5.Less Costly Financing:
Depreciation deduction offers no benefits
to companies with low or no taxable
income. Thus, income tax savings on
depreciation expenses for lessor in high
tax brackets may pass on to the lessee
(with low or no taxable income) in the
form of a reduced rental payment.

Accounting for Leases 12


Advantages of Leasing from
Lessees' Viewpoint :(contd.)
6.Financial reporting benefit (off-balance-
sheet financing) (eliminated by ASU
2016-2):
Off-balance-sheet financing is to acquire the
right to use assets but not to report the
assets and liabilities on the balance sheet.
For an operating lease, the lease does
not add a liability and an asset to the
balance sheet, and therefore does not
affect financial ratios. By maintaining these
ratios, the company's borrowing capacity
can also be maintained.
Accounting for Leases 13
Advantages of Leasing from
Lessees' Viewpoint - An Example
 An example of using leasing to achieve off
balance sheet financing: assuming that in
2015, two identical companies, A and B,
have the following data prior to any new
acquisitions:
 current assets $3,000,000
noncurrent assets 5,000,000
current liabilities 2,000,000
noncurrent liabilities 2,500,000
stockholders’ equity 3,500,000
Accounting for Leases 14
Advantages of Leasing from
Lessees' Viewpoint - An Example
 On December 31, 2015, A company
purchases an equipment with a 5-year life
costing $3,018,400 by signing a 5-year, 8%
note requiring $755,923 to be paid at the
end of each year staring December
31,2016.
 The payments include interests at 8% on the
beginning-of-year principal balance. The
remainder of each annual payment reduces
principal.

Accounting for Leases 15


Advantages of Leasing from
Lessees' Viewpoint - An Example
 A company records the asset
purchased and the note payable. A's
financial data show the following
changes:

Accounting for Leases 16


Advantages of Leasing from
Lessees' Viewpoint - An Example
 noncurrent assets: $5,000,000 + 3,018,400
= $8,018,400

 current liabilities: $2,000,000 + 755,923 x 0.926


= $2,699,985

 noncurrent liabilities: $2,500,000+ (3,018,400


- 699,985)
= $4,818,415

 The rest remains unchanged.

Accounting for Leases 17


Advantages of Leasing from
Lessees' Viewpoint - An Example
Therefore;
Before Acquisition After acquisition
current ratio $3,000,000/$2,000,000 $3,000,000/2,699,985
=1.5 = 1.11
debt to
stockholder
equity $4,500,000/3,500,000 (2,699,985+4,818,415)
$3,500,000
= 1.29 = 2.15
Accounting for Leases 18
Advantages of Leasing from
Lessees' Viewpoint - An Example
 The current ratio falls significantly(from 1.5
to 1.11) while the debt to stockholders’
equity ratio increases 67% after the
acquisition.
 The rate of return on investment in 2015
could also be impaired (due to the increase
of noncurrent assets).
 These adverse impacts on financial ratios
will damage the borrowing capacity of A
company and may also affect its ability to
sell stock.
Accounting for Leases 19
Advantages of Leasing from
Lessees' Viewpoint - An Example
 On the other hand, assume that B
company leases identical equipment by
the use of a lease and agrees to pay
$755,923 rent each year for the next 5
years. If interest rate is 8%, the present
value of the equipment is $3,018,400.
 If the lease is classified as a capital lease,
B records an asset and a liability and the
effects on it's B/S are the same as the
effects of purchase on A's B/S.

Accounting for Leases 20


Advantages of Leasing from
Lessees' Viewpoint :(contd.)
 However, if the lease is classified as an
operating lease, B does not have to
record an asset or a liability.
 Therefore, the financial ratios (i.e., the
current ratio) will be same as before the
acquisition.
 In sum, two identical economic events
(both are acquiring the right to use the
asset)can have very different impact on
key ratios of financial statement(F/S).
Accounting for Leases 21
Advantages of Leasing from
Lessors' Viewpoint :(contd.)
1. A way of indirectly making a sale.

2. An alternative means of engaging in a


profit opportunity. The lease agreement
enables the lessor to earn a normal rate
of return (in a form of interest) on the
cost of leased asset.

Accounting for Leases 22


Classification of Personal property
Leases
 A lease that transfers substantially all the
risks and benefits of ownership to the
lessee represents a purchase by the
lessee and a sale by the lessor and should
be treated as a capital lease (SFAS 13).

 SFAS 13 provides criteria for determining


the classification of leases by both lessees
and lessors.

Accounting for Leases 23


Classification of Leases Involving Personal Property
General Criteria for classifying leases
Exhibit 1
Column A Column B
Criteria Applicable to Both Criteria Applicable to
Lessee and Lessor Lessor Only
a.The lease transfers ownership a.The collectibility of the
of the property to the lessee minimum lease payments
by the end of the lease term. is reasonably assured (i.e.,
b.The lease contains a bargain predictable).
purchase option b.No important uncertainties
c.The lease term is equal to or surround the amount of
greater than 75% of the unreimbursable cost yet to
estimated economic life of the be incurred by the lessor
leased property. under the lease.
d.The present value of the
minimum lease payments
(MLP) is equal to 90% or more
of the fair value of the leased
property to the lessor. Accounting for Leases 24
Classification by the lessee
 Capital lease:
Lease that meets one or more of the criteria
in column A.
Lessee should treat capital lease as a
purchase of asset; recognize leased asset
and obligation under capital lease.
 Operating lease:

Lease that does not meet any of the criteria


in Column A.
Accounting for Leases 25
Classification by the Lessor
 Operating lease:
Lease that meets none of the criteria in col.
A, or does not meet both criteria in col. B.
 Direct Financing leases:

Lease that meets these three criteria:


1. One or more of the four criteria in col. A,
2. Both criteria in col. B, and
3. No manufacture's or dealer's profit.

Accounting for Leases 26


Classification by the Lessor (Contd.)
 Sales-Type leases:
Lease that meets these three criteria:
1. One of more of the four criteria in col. A,
2. Both criteria in column B, and
3. Transaction involves a manufacturer
or dealer's profit (or loss) for the lessor.

Accounting for Leases 27


Classification by the Lessor :(contd.)
 A profit for lessor exists when the fair
market value of the leased property is
greater than its cost or carrying value.
 Items c and d of column A do not apply if
the beginning of the lease term falls within
the last 25% of the total estimated
economic life.

Accounting for Leases 28


Key Terms Related to Leases
 Bargain Purchase Option
A provision allowing the lessee to purchase the
leased property at the end of the life of the lease at
a price so favorable that the exercise of the option
appears, at the inception of the lease, to be
reasonably assured.

 Estimated Economic Life


The remaining life of leased assets for its intended
usage at the inception of the lease contract with
normal repair and maintenance.

Accounting for Leases 29


Key Terms Related to Leases
:(contd.)
 Fair Value of Leased Property
Price for which the property can be sold in
an arm's length transaction between
unrelated parties.

 For manufacturers and dealers, the fair


value is the selling price. For others, the fair
value is the cost of the asset to the lessor.

Accounting for Leases 30


Key Terms Related to Leases
:(contd.)
 Periodic Lease Payments and Minimum Lease
Payments(MLP):
 Periodic lease payments are payments required
to be paid by the lessee to the lessor over the life
of the lease.
 For a lease with a bargain purchase option (BPO),
the MLP include (for both lessee and lessor):
1.The periodic lease payments required over
the lease term; plus
2. The payment required by the BPO.
Accounting for Leases 31
Key Terms Related to Leases
:(contd.)
 Otherwise, the MLP include:
1. The periodic lease payments, plus
2. Any guaranteed residual value*, and
3. Any payments on failure to renew or
extend the lease if the agreement specifies
that the lease must be extended or
renewed.
* For a lessee, the residual value must be guaranteed by
the lessee; for a lessor, it can be guaranteed by either
the lessee or a third party.
Accounting for Leases 32
Key Terms Related to Leases
:(contd.)
 Thus, a lessee's MLP could be less than a
lessor's when the residual value is
guaranteed by a third party.
 Leased Assets for a lessee = the Present
Value (PV) of the MLP, Not to exceed the
fair market value of the asset.
 Note: For a lessor, the present value of the
MLP should equal the cost/fair value.

Accounting for Leases 33


Key Terms Related to Leases
:(contd.)
 Executory costs are ownership-type costs
(I.e., insurance, maintenance and property taxes).
 It is expected to be paid by the party with the
ownership.
 In the case of capital lease (lessee assumes

the ownership), if portion of the lease payment


is for the reimbursement of the executory
costs to the lessor, it should be subtracted
from MLP computation.
Accounting for Leases 34
Accounting for Leases -Treatment
of operating leases:
Terms and provisions of lease agreement between
landlord company (lessor) and tenant company
(lessee) dated January 1, 2015
1.The lease term is 5 years. The lease is
noncancelable and requires equal rental payments
of $50,000 at the beginning of each year.
2.The cost, and also fair value, of the equipment to
the Landlord Company at the inception of the lease
is$400,000. The equipment has an estimated
economic life of 10 years and has a zero estimated
residual value at the end of this time.

Accounting for Leases 35


Accounting for Leases -Treatment
of Operating Leases: (contd.)
3.There is no guarantee of the residual value by the
Tenant Company.
4.The Landlord Company agrees to pay all executory
costs.
5.The equipment reverts to the Landlord Company at
the end of the 5 years;
6.The Tenant Company's incremental borrowing rate
is 12.5% per year.
7.For the Landlord Company, the interest rate implicit
in the lease is 12%.
8.The present value of an annuity due of 5 payments
of $50,000 each at 12% is 4.037349 * $50,000 =
$201,867.45
Accounting for Leases 36
Application of Criteria for Determination
of Lease Classification by Lessees
Classification Criteria Criteria Met? Remarks
1. Transfer of ownership at end of lease No
2. Bargain purchase option No
3. Lease term is 75% of economic life No It is 50%
4. Present value of lease payments is 90%
of fair value No The present
value is
$201,867.45,
or 50.5% of fair
value
Conclusion: the lease is an operating lease. It meets none of the
criteria.

Accounting for Leases 37


Journal Entries – An Operating Lease for
the Lessee
 The only journal entry recorded by the lessee is:
1-1-15
Rent Expense 50,000
Cash 50,000
Similar entries will be recorded at the beginning of
2016 through 2019.
Under the operating lease, neither an asset nor a
liability is recognized.

Accounting for Leases 38


Accounting and Reporting by
Lessors
Types of leases classified by lessor:
1.Operating lease.
A lease that meets none of the criteria in
col. A or does not meet both criteria in col. B of
Exhibit 1.
2.Direct-financing lease.
A lease that meets one or more of the criteria in
col. A and both criteria in col. B of Exhibit 1.
Also the lease involves no manufacturer's or
dealer's profit.

Accounting for Leases 39


Accounting and Reporting by
Lessor:(Contd.)
3. A Sales-type lease.
A lease meets one or more of the criteria in
col. A and both criteria in col. B of Exhibit 1.
Also, the lease involves the recognition of a
manufacturer's or dealer's profit (or loss).

4. Leveraged lease (skip).


A special three-party lease which is
considered to be a direct-financing lease.

Accounting for Leases 40


Operating Leases: (Lessors)
 Under an operating lease, the lessor retains
substantially all the risk and benefit of
ownership.
 The leased equipment is reported on the

balance sheet of the lessor in Property, Plant


and Equipment subsection entit led “Equipment
Leased to Others" and record depreciation.
The lessor usually pays the executory fees and

records them as operating expenses.

Accounting for Leases 41


The Accounting Treatment of
Operating Leases -Lessors
 Example: assume that landlord Company
(lessor) Leases a piece of equipment to Tenant
Co. (lessee) for 5 years under the terms
described on pages 34 and 35.
Tenant agrees to pay $50,000 at the beginning
of each year.
The equipment was purchased by Landlord at a
cost of $400,000. It has an estimated life of 10
years.

Accounting for Leases 42


Operating Leases- Lessors (contd.)
 Landlord uses straight-line depreciation
method.
 On 1/10/15, the lessor pays the annual
insurance premium of $2,000 and
on12/15/15, it pays for repair expense of
$1,500.
 Assuming no initial direct costs, the
preceding information is recorded in the
following journal entries:

Accounting for Leases 43


Operating Leases-Lessors (contd.)
 Purchase of equipment to be leased on 1/1/15:
Equipment leased to others 400,000
Cash (or Equipment)* 400,000
*if equipment was already owned
Collection of annual payment on operating lease
on 1/1/15:
Cash 50,000
Unearned Rent Revenue 50,000

Accounting for Leases 44


Operating Leases- Lessors (contd.)
 1/10/15 Recording insurance expense (an executory cost)
 Insurance expense 2,000
Cash 2,000
 12/15/15 Recording repair expense
 Repair expense 1,500
Cash 1,500
 12/31/15 Recording rent revenue and annual depreciation
Unearned Rent Revenue 50,000
Rent Revenue 50,000
Depr. Exp.: Equip. leased to others 40,000
Acc. Depr.: Equip. leased to others 40,000
(400,000/10 = 40,000)

Accounting for Leases 45


Accounting for Leases - Treatments
for Capital Leases
 When a lease is reported as a capital
lease, Lessee records an asset (i.e., leased
asset) and a liability (i.e., Lease Liability).

The amount of leased asset equals


lease liability and is calculated as the
present value of the MLP.

Accounting for Leases 46


Accouning Treatments for Capital
Leases
 For a capital lease, the lessee is usually
responsible for the executory costs.

 If the executory costs are paid by the


lessor, they should be deducted from
the lease payments in computing the
present value of the MLP.

Accounting for Leases 47


Discount Rate used in computing
the present value of MLP
 In computing the PV of the MLP, lessee
should use the lower of
 The lessee's incremental borrowing
rate, or
 The lessor's implicit interest rate (the
discount rate used by the lessor; the
rate of return the lessor intends to
earn).
 If b is unknown to the lessee, the lessee
would uses its incremental borrowing rate.
Accounting for Leases 48
Discount Rate used in computing
the present value of MLP (cont.)
The present value of the MLP may be
different for a lessee and a lessor when
different discount rates are used in
computing the PV of the MLP.
The lower the rate is, the higher the PV

of the MLP.

Accounting for Leases 49


Depreciation/Amortization Criteria for
Leased Assets - for Lessees
Lease Agreement
No
Yes
Ownership Transferred?
No a.
Yes
Bargain Purchase Option Lessee Depreciates
No
Assets Over
Lease Term >= Yes Economic Life
75% of Asset’s Life
No b.
Yes
MLP  90% of FV Lessee Depreciates
No Assets
Lessor Depreciates Over Lease Term
Asset Over Economic Life
Accounting for Leases 50
Depreciation or Amortization Criteria
for Leased Assets – for Lessee(contd.)
a.Depreciates to the estimated residual
value.
b.Depreciates to the lessee’s guaranteed
residual value (if any). If no guaranteed
residual value, depreciate to zero.
* Both "Amortization" and "depreciation term
can be used. FASB uses "Amortization “
more often due to leased asset is an
intangible.

Accounting for Leases 51


The Accounting Treatments for
Capital Lease-Lessor
 The cost or the fair market value of the leased
equipment for the lessor can be derived as:
P.V. of lease payments a
+ P.V. of residual value (guaranteed or not) or BPO
cost of the leased equipment
a. if a portion of the lease payments is to cover
the executory costs paid by the lessor, it should
be subtracted.
 Thus, the lease payment calculated by the lessor
equals: (Cost – PV of residual value or BPO)/ the
annuity factor. For the lessor, the PV of the MLP
equals the cost/fair value.
 Accounting for Leases 52
Examples and Accounting Treatments
for Capital Leases
Example A1: Equipment is leased under an
agreement without a transfer of ownership, a
bargain purchase option or a guaranteed RV.

 Terms and provisions of lease agreement


between Kingston leasing company (lessor) and
Johnson company (lessee) dated January
1,2015:The lease term is 4 years. The lease is
noncancelable and requires equal payments of
$35,923.45 (including $3,000 executory cost)
at the end of each year.
Accounting for Leases 53
Example A1 (contd.)
2. The cost, and also fair value, of the equipment
to Kingston (lessor) at the inception of the lease
is $100,000.
3. The equipment has an estimated economic life
of 4 years and has a zero estimated residual
value at the end of lease term.
4. There is no guarantee of the residual value
by the Johnson Company.
5. Johnson (lessee) pays all executory costs
directly to third parties except for the property
taxes of $3,000 per year, which is included as
part of tis annual payments to Kingston(lessor).
Accounting for Leases 54
Example A1 (contd.)
6. Johnson’s (lessee) incremental borrowing
rate is 12.5% per year.
7. Kingston's (lessor)implicit interest rate is
12%. Johnson Company knows this rate.
8. The annual lease payment (MLP) charged
by the lessor is calculated as follow:
($100,000 - $0) / 3.037349a = $32,923.45
 Since Johnson is responsible for all executory costs,
Johnson would pay $35,923.45 to Kingston each year to
cover $32,923.45 lease payment and $3,000 property tax.
a. P.V. factor of an ordinary annuity of $1 for 4
periods at 12% interest rate.
Accounting for Leases 55
Example A1 (contd.)

 Note 1: If there is any RV or BPO, the P.V. of the


RV (guaranteed or not) or BPO should be
subtracted from the cost of $100,000 in computing
the lease payment.
 Note 2: The present value of an ordinary annuity of
four payments of $32,923.45 ($35,923.45 - $3000
executory cost) at 12% is $100,000, calculated as
follows:
$32,923.45 x 3.037349 = $100,000.

Accounting for Leases 56


The Accounting Treatments for
Capital Lease
9. The equipment reverts to Kingston at the
end of the 4 years.
10.Johnson Company uses the straight-line
method to record depreciation on similar
equipment's.
11.The collectibility of rental is reasonably
assured and no uncertainties involved in
the lease;
12. No initial direct costs.

Accounting for Leases 57


Application of criteria to determine the lease
classification by Lessee and Lessor:
Classification Criteria Criteria Met? Remarks
1. Transfer of ownership at end of lease No Title reverts
to lessor
2. Bargain purchase option No
3. Lease term is 75% or more of economic life Yes 100% of
estimated life
4. Present value of MLP is 90% or more
of fair value Yes The Present
value is
$100,000, or
100% of the fair
value

Accounting for Leases 58


The Accounting Treatment for
Capital Lease (Lessor):(contd.)
The lease is a capital lease for the lessee
because it meets two of the four criteria under
Column A (on p21) .
 The lease is a direct financing lease for the
lessor because :
1. it meets two of the four criteria under

Column A and both criteria under


coloumn B (on p21) ; and
2. No dealer or manufacturer’s profit.

Accounting for Leases 59


Journal Entries for Example A1- Lessee

 The journal entries to record the acquisition of the


leased asset, the amortization (depreciation) for 4
years by the lessee are as follows:

1. Initial Recording of capital lease on 1/1/2015


Leased Equipment* 100,000
Lease Liability 100,000

*PV of lessee’s MLP = $32,923.45 * 3.037349 =


100,000)
Accounting for Leases 60
Journal Entries for Example A1 – Lessee (cont.)

2. First payment (on 12/31/2015):

Interest Expense 12,000*


Lease Liability 20,923
Property Tax Expense 3,000

Cash 35,923
• 100,000 * 12% = 12,000

•Effective interest method: Interest Expense = the P.V.


of the liability x interest rate.
Accounting for Leases 61
Journal Entries for Example A1- Lessee (contd.)

3.Recognition of annual depreciation of leased


equipment on 12/31/2015:

Depreciation Expense: Leased Equip.* 25,000


Acc. Depreciation: Leased Equip. 25,000

* The asset is amortized over the lease term to the lessee’s


guaranteed RV or zero because the lease does not include a
transfer of ownership or a BPO. Also, depreciate to zero due to no
guaranteed RV by the lessee.

Accounting for Leases 62


Journal Entries for Capital Lease (Lessee): (contd.)
Reporting:Balance Sheet (12/31/2015)
Assets Liabilities:
PPE Current Liability:

Leased Equipment 100,000 Lease Liability 23,434a

Acc. Depr.:Leased Equip (25,000) Long-Term Liability:

Lease Liability 55,643b


a. 32,923.45-(100,000-20,923)*0.12=23,434

b. 100,000 - 20,923 - 23,434 = 55,643

Accounting for Leases 63


Journal Entries for Example A1- Lessee (contd.)

4. Payment on 12/31/2016:
Interest Expense 9,489.191
Lease Liability 23,434.262
Property Tax Expense 3,000
Cash 35,923.45

1.P.V. of liability at the beginning of 2016 * 12%


= (100,000-20,923.45) * 12% = 9,489.12
2. 32,923.45 - 9489.19 = 23,434.26

5. Depreciation Expense of 2016:


Depreciation Expense: Leased Equip. 25,000
Acc. Depreciation : Leased Equip 25,000

Accounting for Leases 64


Journal Entries for Example A1- Lessee (contd.)

2017: Interest Expense 6,677.17


Lease Liability 26,246.38
Property Tax Expense 3,000
Cash 35,923.45
Depreciation Expense : L. E. 25,000
Acc Depreciation: L.E 25,000
2018:Interest Expense 3,527.54
Lease Liability 29,395.91
Property Tax Expense 3,000
Cash 35,923.45
Depreciation Expense : L. E. 25,000
Acc Depreciation: LE 25,000
Accounting for Leases 65
Journal Entries for Example A1- Lessee (contd.)
Selected account balance at the end of the
lease term:
Lease Liability = $0
Acc. Depreciation = $100,000
Leased Equipment = $100,000
 Upon expiration of the lease if Johnson does
not purchase the leased equip. and returns the
equip. to Kingston, the following entry will be
recorded:
Acc. Depre. 100,000
Leased Equip. Accounting for Leases
100,000 66
Journal Entries for Example A1- Lessee (contd.)
 If Johnson purchases the leased equip. at
termination of the lease for 2000, the following
entry will be recorded:
Equipment 2,000
Accu. Depre. 100,000
Leased Equip. 100,000
Cash 2,000

Accounting for Leases 67


Example A1: Summary of lease payments
and interest expense of Example A1 - Lessee
Payments at End of Year

Annual Lease 12% on the balance Reduction of Balance of Lease


a b
Date Payment lease payable Lease Payable Payable
1/1/2015 - - - $100,000.00
12/31/2015 $32,923.45 $12,000.00 $20,923.45 79,076.55
12/31/2016 32,923.45 9,489.19 23,434.26 55,642.29
12/31/2017 32,923.45 6,677.07 26,246.38 29,395.91
12/31/2018 32,923.45 3,527.54d 29,395.91 0
Total 131,694 $31,694 $100,000

Accounting for Leases 68


Summary of Lease Payments and Interest
Expense of Johnson company (contd.)
a. Column 5 at beginning of year * 12 %, the
effective interest expense
b. Column 2 - Column 3
c. Column 5 at beginning of year - Column 4
d. adjusted for rounded error of 0.03.
 For capital leases, executory costs paid by the
lessee are recorded as operating expenses.
 If these costs are paid by the lessor and

reimbursed by the lessee (as the $3,000


property tax in Example A, they should be
deducted from the payment to obtain the MLP).
Accounting for Leases 69
Comparison of Capital Lease Expense and
Operating Lease Expense (pre-tax) - Lessee
Year Operating Capital lease Difference Cumu.
Lease Expense (impact on Difference
Rental (Interest income) (impact on
Expense Expense R/E)
+Depre. Exp.)

2015 $32,923 (12,000+25,000) -$4.077 -$4,077

2016 $32,923 (9,489+25,000) -$1,566 -$5,643

2017 $32,923 (6677+25,000) $1,246 -$4,396

2018 $32,923 (3,528+25,000) $4,395 $0

Accounting for Leases 70


Comparison (contd.)
 Capital lease expense is greater than that of
operating lease expense for 2015 and 2016.
However, this phenomenon is reversed in
2017 and 2018.
 The income impact of lease capitalization is
negative for 2015 and 2016, but is positive
for 2017 and 2018.
 The lease capitalization impact on retained
earnings is always negative during the lease
term and is zero when the lease term is up.
Accounting for Leases 71
Journal Entries of Example A1- A Direct Financing
Lease for the Lessor:
The journal entries to record the lease of the
equipment and the receipts of 4 lease
payments for the lessor are as follows:

1. Initial Recording of capital lease on


1/1/2015
Lease Receivablea 100,000
Equipmentb 100,000

Accounting for Leases 72


Example A1 – Lessor (cont.)
a. Lease Receivable (LR) = annual Lease
Payment (excluding executory costs) x PV
factor of an ordinary annuity at 12%+ the
PV of the residual value (guaranteed or
not) or BPO if any = ($35,923.45 – $3,000)
x 3.037349 + $0 = $100,000.
b. Equipment = cost of leased asset= the fair
market value of the leased asset under a
direct financing lease

Accounting for Leases 73


Journal Entries for Example A1 ( a direct financial
Lease for the Lessor (contd.)
2. First payment received by lessor (on 12/31/2015):

Cash 35,923.45
Lease Receivable 20,923.45**
Interest Revenue 12,000*
Property Tax Payable 3,000
*100,000 (lease receivable) x 12% = 12,000

** 35,923.45-12,000

Accounting for Leases 74


Example A1- Lessor (contd.)
Reporting lease receivable (LR) is divided into
current and noncurrent portions for B/S reporting
purposes.

Current Noncurrent Total LR


23,434.26 a 55,636.30b 79,076.55
a. 32,923.45-(100,000-20,923)*0.12=23,434

b. 100,000 - 20,923 - 23,434 = 55,643

Accounting for Leases 75


Journal Entries for Example A1-Lessor (contd.)

 2016:
Cash 35,923.45
Lease Receivable 23,434.26
Interest Revenue 9,489.19*
Property Tax Payable 3,000

* (100,000- 20,923.45)x0.12 = 9,489.19


 2017:
Cash 35,923.45
Lease Receivable 26,248.38
Interest Revenue 6,677.07*
Property Tax Payable 3,000
* (100,000- 20,923.45- 23,434,26)x0.12 = 6,677.07
Accounting for Leases 76
Journal Entries for Example A1-Lessor (contd.)

 2018:
Cash 35,923.45*
Lease Receivable 29,395.91
Interest Revenue 3,527.54
Property Tax Payable 3,000

*(100,000- 20,923.45- 23,434,26 -26,248.38)x0.12 = 3,527.54

Accounting for Leases 77


Journal Entries for Example A1- Lessor (contd.)

 At the end of the lease term,


 lease receivable =0

 Assume the market value of the reverted


leased asset is $2,000, the following entry will be
recorded(due to zero residual value is assumed
for the leased asset) by the lessor:
Equipment 2,000
Gain 2,000

Accounting for Leases 78


Summary of lease payments received and
interest revenue : Exhibit A1-Lessor
Payments at End of Year

Annual Lease 12% on lease Reduction of Lease


Date Payment Receviable Lease Receviable Receviable Balance
1/1/2015 - - - $100,000.00
12/31/2015 $32,923.45 $12,000.00 $20,923.45 79,076.55
12/31/2016 32,923.45 9,489.19 23,434.26 55,642.29
12/31/2017 32,923.45 6,677.07 26,246.38 29,395.91
12/31/2018 32,923.45 3,527.54d 29,395.91 0
Total 131,694 $31,694 $100,000

Accounting for Leases 79


The Accounting Treatments for
Capital Lease-Lessor(contd.)
 The MLP for both lesser and lessor
equals:
The annual payments + guaranteed
residual value a or BPO
a. For a lessee, the RV needs to be
guaranteed by the lessee.
For a lessor, the RV can be guaranteed
by a lessee or by a third party.

Accounting for Leases 80


The Accounting Treatment for
Capital Lease -Lessor
 Thus, it is possible that a lease is
reported as an operating lease by the
lessee while is reported as a capital
lease by the lessor.
 Method: with a large amount of RV
guaranteed by a third party.

Accounting for Leases 81


Capital Leases : Payments in Advance
with Zero RV – Example A2
 Example A2:
 Assume all the lease provisions are the
same as in example A1 except that the
lease payments are made at the
beginning of each year. Also, the cost
also the fair value of the equipment is
$112,000, not $100,000.

Accounting for Leases 82


Capital Leases : Payments in Advance
with Zero RV – Example A2
Lessor will compute the periodic lease
payment as follows:
($112,000 - $0a) / 3.401831bb = 32,923.42
a. PV of the residual value (guaranteed or not) or BPO.
b. PV of an annuity due of $1 for 4 periods at 12% dis. rate

P.V. of the MLP for both the lessee and lessor =>
$32,923.42 x 3.401831 + $0c = $112,000.
 The lease is a capital lease for the lessee
and a direct financing lease for the lessor.
Accounting for Leases 83
Journal Entries for Example A2-
Lessee
 Initial Recording
Leased Equip.* 112,000
Lease Liability 112,000
*PV of lessee’s MLP = $32,923.45 * 3.40183 = 112,000)
 Payment on 1-1-2015 (the inception of the lease)
Lease Liability 32,923.45
Property Tax Expense 3,000
Cash 35,923.45
 Recording of Depreciation on 12/31/2015 (also on
12/31/2016, 12/31,2017, and 12/31/2018)
Depreciation Expense-Leased Equipment 28,000
Acc. Depreciation-Leased Equipment 28,000
Accounting for Leases 84
Example A2 –Lessee (Cont.)
 Recording accrued Interest Expense:
12/31/2015 Interest Expense 9,489.19a
Interest Payable 9,489.19

a. (112,000 -32,923,45) * 12%


 Second annual payment in advance on 1/1/2016:
Lease Liability 23,434.26
Interest Payable 9,489.19
Property Tax Expense 3,000
Cash 35,923.45

Accounting for Leases 85


Example A2 –Lessee (Cont.)
 Recording 2016 accrued Interest Expense on
12/31/2016
Interest Expense 6,677.07*
Interest Payable 6,677.07

*(112,000 -32,923,45 -23,434,26) * 12%


 Third annual payment in advance on 1/1/2017:
Lease Liability 26,246.38
Interest Payable 6,677.07
Property Tax Expense 3,000
Cash 35,923.45

Accounting for Leases 86


Example A2 –Lessee (Cont.)
 Recording 2017 accrued Interest Expense on
12/31/2017
Interest Expense 3,527.54
Interest Payable 3,527.54

*(112,000 -32,923,45 -23,434,26-26,246.38) * 12%


 Fourth annual payment (the last MLP)in advance
on 1/1/2018:
Lease Liability 29,395.91
Interest Payable 3,527.54
Property Tax Expense 3,000
Cash 35,923.45
Accounting for Leases 87
Example A2 -Lessee
 On 12/31/2018, the balances of Lease
Liability and accumulated depreciation of
leased equipment are zero and 112,000,
respectively.
 The following entry is recorded on 12/31/2018,
at the end of the lease term:
Acc. Depre. 112,000
Leased Equip. 112,000
Note: No accrued interest on 12/31/2018 due to the
Lease Liability has been paid off on 1/1/2018.
Accounting for Leases 88
Summary of lease Payments and Interest Expense of
Johnson company (Lessee):
Exhibit A2: Payments in Advance
 Date Annual Lease
payment
Accrued Interest
at 12% of the
Reduction of
Lease
Balance of
Lease
balance of Lease
Liability Liability Liability
12/31/2014 $112,000
1/1/2015 $32,923.45 $0 $32,923.45 79,076.55

12/31/2015 $9,489.19
1/1/2016 $32,923.45 $23,434,26 $55,642.29

12/31/2016 $6,677.07
1/1/2017 $32,923.45 $26,246.38 $29,395.91

12/31/2017 $3,527.54
1/1/2018 $32,923.45 $29,395.91 $0
Total $131,693.80 $19,693.80 $112,000
Accounting for Leases 89
Journal Entries for Example A2 -Payments in
Advance with zero RV- Lessor
 Initial Recording on 1/1/2015
Lease Receivable* 112,000
Equipment 112,000
*Lease Receivable = annual Lease Payment (excluding executory costs) x PV
factor of an annuity due at 12%+ the PV of the residual value (guaranteed or
not) or BPO if any. Lease Receivable= $32,923.42 x 3.401831+ $0c = 112,000.

 Record lease payment received on 1/1/2015


Cash 35,923.45
Lease Receivable 32,923.45
Property Tax Payable 3,000
 Recognize the interest earned on 12/31/2015
Interest Receivable 9,489.19
Interest Revenue 9,489.19
Accounting for Leases 90
Example A2 - Lessor(Contd.)
 Record lease payment received on 1/1/2016:
Cash 35,923.45
Lease Receivable 23,434.26
Interest Receivable 9,489.19
Property Tax Payable 3,000
 Interest revenue earned recognized on 12/31/2016
(see p88 for interest revenue of 2016) :
Interest Receivable 6,677.07
Interest Revenue 6,677.07
 Record lease payment received on 1/1/2017
Cash 35,923.45
Lease Receivable 26,246.38
Interest Receivable 6,677.07
Property Tax Payable
Accounting for Leases
3,000 91
Example A2 - Lessor(Contd.)
 Interest revenue earned in 2017 recognized on
12/31/2017:
Interest Receivable 3,527.54
Interest Revenue 3,527.54
 Record lease payment received on 1/1/2018
Cash 35,923.45
Lease Receivable 29,395.91
Interest Receivable 3,527.54
Property Tax Payable 3,000

Accounting for Leases 92


Comparison of Operating Lease Revenue
Capital Lease Revenue (pre-tax)- Lessor
Year Operating Operating Operating Capital Difference Cumu.
Lease Lease Lease Lease (Operating Difference
Rental Depreciation Revenue - Interest Lease Rev. (impact on
Revenue Expense Net revenue – Capital R/E)
lease
revenue)

2015 $32,923 $25,000 $7,932 $12,000 -$4.077 -$4,077

2016 $32,923 $25,000 $7,932 $9,489 -$1,566 -$5,643

2017 $32,923 $25,000 $7,932 $6677 $1,246 -$4,396

2018 $32,923 $25,000 $7,932 $3,528 $4,395 $0

Accounting for Leases 93


Example A2 – Lessor (contd.)
At the end of lease term:
Lease Receivable = 0
When the leased asset is reverted back to the
lessor on 1/1/2019,the following entry will be
recorded if the market value of the leased
equipment is $300:
Equipment 300
Gain on Capital Lease 300

Accounting for Leases 94


Guaranteed Residual Value
 Guaranteed residual value (RV):
The RV of the leased property which is
guaranteed by the lessee (or by a third
party not related to the lessor).
 The MLP of lessees will include the
guaranteed RV only if the RV is guaranteed
by the lessee.
 For lessors, the RV will be included in their
MLP as long as it is guaranteed .
Accounting for Leases 95
Guaranteed Residual Value (contd.)

 If the residual value is guaranteed and the


fair market value of the leased property at
the end of the lease term is less than the
guaranteed amount, the guarantor has to
pay the difference to the lessor.

 Lease provisions could have a


guaranteed residual value only if there is
no ownership transfer and no BPO.
Accounting for Leases 96
Payments in Advance with
Guaranteed Residual Value
 Example A3:
 Assume the lease provisions are the
same as in Example A2 except that
there is a guaranteed residual value of
$1,000 by the lessee. Also, the cost
also the fair value of the equipment is
$112,635.5 (not $100,000 as in A1 or $112,000
as in A2).

Accounting for Leases 97


Payments in Advance with
Guaranteed Residual Value (contd.)
 The lessor calculates the lease payment as:
(Cost – PV of residual Value)a,b/ 3.401831 =>
(112,635.5 - 1,000 x 0.6355)/3.401831=
32,923.45
a. The residual value (RV) is used as a factor to
determine the amount to be recovered from the
lessee (i.e., the lease payment).
b. In deriving the lease payments, lessors will subtract
the residual value (RV) regardless guaranteed or
not. However, to be included in the lessor’s MLP,
the RV has to be guaranteed. Also, to be included
in the lessee’s MLP, it has to be guaranteed by the
lessee.
Accounting for Leases 98
Payments in Advance with
Guaranteed Residual Value (contd.)
 Major factors determining the implicit interest
rate of a lessor: the risk of the lessee,
whether the RV is guaranteed and the
conditions of the credit market
 P.V. of MLP for both lessee and lessor is =>
$32,923.45 * 3.401831+$1,000 * 0.6355
= $112,635.5
 The lease is a capital lease for the lessee
and a direct financing lease for the lessor.

Accounting for Leases 99


Journal Entries for the Lessee-
Example A3
1. Initial Recording
Leased Equipment 112,635.5
Lease Liability 112,635.5
PV of lessee’s MLP = $32,923.45 * 3.401831+$1,000 * 0.6355= $112,635.5
2. Payment on 1-1-2015 (at the inception of the lease)
Lease Liability 32,923.45
Property Tax Expense 3,000
Cash 35,923.45
3. Recording the Depreciation on 12-31-2015 (similar entry will be
performed for 2016,2017 and 2018)
Depreciation Expense:
Leased Equipment (112,635-1,000)/4 27,909
Acc. Depreciation: Leased Equipment
Accounting for Leases
27,909 100
Journal Entries for A3- Lessee (contd.)
4. Recording accrued Interest Expense:
12-31-2015 Interest Expense 9,565.45a
Interest Payable 9565.45

a. (112,635.5 -32,923,45) * 12%

5. 2nd annual payment in advance on 1/1/2016:


Lease Liability 23,358
Interest Payable 9,565.45
Property Tax Expense 3,000
Cash 35,923.45
Accounting for Leases 101
Payments in Advance with
Guaranteed Residual Value-lessee (contd.)
6. Recording accrued Interest Expense:
12-31-2016 Interest Expense 6762.49a
Interest Payable 6762.49

a. (112,635.5 -32,923.45-23,358) * 12%

7.3rd annual payment in advance on 1/1/2017:


Lease Liability 26,160.96
Interest Payable 6,762.49
Property Tax Expense 3,000
Cash 35,923.45

Accounting for Leases 102


Payments in Advance with
Guaranteed Residual Value-Lessee (contd.)
8. Recording accrued Interest Expense on 12/31/2017
Interest Expense 3623.17a
Interest Payable 3623.17

a. (112,635.5 -32,923.45-23,358-26,160.92) * 12%

9.4th annual payment in advance on 1/1/2018:


Lease Liability 29,300.28
Interest Payable 3,623.18
Property Tax Expense 3,000
Cash 35,923.45

Accounting for Leases 103


Payments in Advance with
Guaranteed Residual Value –Lessee (cont.)
10. 12/31/2018:
Interest Exp. 107.14a
Interest Payable 107.14
a. (112,635.5 -32,923,.5-23,358-26,160.92-29,300.27) x12% = 892.86 x
0.12 = 107.14
 1/1/2019 (if FV of the leased asset is greater or equal the
guaranteed residual value of $1,000)
Interest Payable 107.14
Lease Liability 892 .81
Accumulated Depreciation 111,635 .50
Leased Equip. 112,635.50
Note: A gain may be recognized when the fair value exceeds $1,000. The
lessor and the lessee may share the gain.
Accounting for Leases 104
Payments in Advance with
Guaranteed Residual Value-lessee (contd.)
 1/1/2019 (if the FV of the leased asset = $300)
Interest Payable 107.14
Lease Liability 892.86
Accumulated Depreciation 111,635.5
Leased Equip. 112,635.5
Loss on Capital Lease* 700
Cash 700
*This is due to the lessee guaranteed the RV of
$1,000.

Accounting for Leases 105


Summary of lease Payments and Interest Expense of Johnson
company (Lessee) - Example A3: Payments in Advance with
Residual Value Guaranteed by the Lessee
 Date Annual Lease
payment
Accrued Interest
at 12% of the
Reduction of
Lease
Balance of
Lease
balance of Lease
Liability Liability Liability
1/1/2015 $112,635.50
1/1/2015 $32,923.45 $0 $32,923.45 79,712.05
12/31/2015 $9,565.45
1/1/2016 $32,923.45 $23,358,00 $56,354.05
12/31/2016 $6,762.49
1/1/2017 $32,923.45 $26,160.96 $30,193.09
12/31/2017 $3 623.17
1/1/2018 $32,923.45 $29,300.28 $892.81
12/31/2018 107.14
1/1/2019 $1,000 (guaranteed RV) $892.86 $0
Total $132,693.80 $20,058.25 112,635.55
Accounting for Leases 106
Journal Entries of Example A3 (Payment in
Advance with Guaranteed Residual Value by
the Lessee) -Lessor
1. Initial Recording
Lease Receivable 112,635.5*
Equipment 112,635.5
*Lease Receivable = Lease Payment (excluding executory
costs) x PV factor of an annuity due at 12%+ the PV of
the residual value (guaranteed or not) or BPO if any.
Lease Receivable = $32,923.42 x 3.401831 + $1,000 x
0.6355= 112,635.5.
2. Payment on 1-1-2015 (at the inception of the lease)
Cash. 35,923.45
Lease Receivable 32,923.45
Property Tax Payable 3,000
Accounting for Leases 107
Journal Entries for A3 -Lessor
3. Recording accrued Interest revenue on 12/31/2015:
Interest Receivable 9,565.45a
Interest rev. 9,565.45
 Accrued int. = balance of Lease Liability x 12% = (112,635.5-
32,923.45) x 12% = interest expense of the lessee
4. Second lease payment on 1/1/2016:
Cash 35,923 .45
Lease Receivable 23,358
Interest receivable 9565.45
Property Tax Payable 3,000
 Accounting for Leases 108
Journal Entries for A3 -Lessor
5. Recording accrued Interest revenue on 12/31/2016:
Interest Receivable 6,762.49a
Interest rev. 6,762.49
 (112,635.5-32,923.45-23,358) x 12%
6. Third lease payment on 1/1/2017:
Cash 35,923 .45
Lease Receivable 26,160.96
Interest receivable 6,762.49
Property Tax Payable 3,000

Accounting for Leases 109


Journal Entries for A3 -Lessor
7. Recording accrued Interest revenue on 12/31/2017:
Interest Receivable 3,623.17a
Interest rev. 3,623.17
 (112,635.5-32,923.45-23,358-26,160.96) x12%
8. Fourth lease payment on 1/1/2018:
Cash 35,923 .45
Lease Receivable 29,300.28
Interest receivable 3,623.17
Property Tax Payable 3,000

Accounting for Leases 110
Journal Entries for A3 -Lessor
9. Recording accrued Interest revenue on 12/31/2018:
Interest Receivable 107.14a
Interest rev. 107.14
 (112,635.5-32,923.45-23,358-26,160.96-29,300.28) x12%

Accounting for Leases 111


Example A3 (Payments in Advance with
Guaranteed Residual Value) -lessor (contd.)
 On 1/1/2019, the balance of Lease
Receivable = $892.86 (the PV of the
guaranteed RV at the inception of the lease).
The following entry will be recorded when
the leased asset is reverted back to the
lessor with a market value of $700:
Equipment 700
Cash 300
Lease Receivable 892.86
Interest Receivable 107.14

Accounting for Leases 112


Payments in Advance with
Guaranteed Residual Value- Lessor
(contd.)
 The difference between the market value $700
and the guaranteed RV of $1,000 (i.e., $300)
will be paid by the guarantor (either the lessee
or a third party).
 If the residual value is not guaranteed by
anyone, the cash account will be replaced by a
loss account.
 Therefore, in deriving the lease payment,
lessors will subtract the RV regardless
guaranteed or not and the journal entries for the
lessors are the same as above except replacing
the cash by a loss account.
Accounting for Leases 113
Lessee: Payments in Advance with Residual
Value Guaranteed by a third party or Unguaranteed
 If the residual value is not guaranteed or
guaranteed by a third party, the residual value
is excluded from the MLP of the lessee and the
component of MLP is only the annual lease
payments.
 Using Example A3 and assuming that $1,000
RV is unguaranteed, the MLP of lessee =
$32,923.45 * 3.401831 = $112,000
 The accounting treatment for the lessee is the
same as in Example A2 (pp84-89; the case of
zero residual value) if it is still qualified as a
capital lease for the lessee.
Accounting for Leases 114
Payment in Advance with BPO
 Example A4: Assume lease provisions are
the same as in example A2 except that there
is a bargain purchase option at $1,000 with
the eco. life of the leased asset increased
from 4 to 10 years.
 The cost (also the fair value) of the
equipment is $112,635.5.
 The expected residual value (not guaranteed
by any party) is $2,635.5.
Accounting for Leases 115
Payment in Advance with BPO (contd.)
 The MLP charged by the lessor is derived as
($112,635.5 – 1000 x 0.6355a)/3.401831b = $32,923.45
a. the present value factor of 4 periods at 12%
b. The annuity due factor of 4 periods at 12%

 PV of the MLP for both lessee and lessor =


$32,923.42 * 3,401831+$1,000 * 0.6355 =
$112,635.5 = 100% of the cost
 The lease is a capital lease for the lessee
and a direct financing lease for the lessor
Accounting for Leases 116
Journal Entries for A4 (Payment in
Advance with BPO) - Lessee
1. Initial Recording
Leased Equip* 112,635.5
Lease Liability 112,635.5
* PV of Lessee’s MLP = PV of lease payments +PV of BPO
2. Payment on 1-1/2019 (the inception of the lease)
Lease Liability 32,923.45
Property Tax Expense 3,000
Cash 35,923.45
3. Recording of Depreciation on 12-31-2015 (similar
entry will be recorded for 2016,2017 and 2018)
Depreciation Expense 11,000a
Acc. Depreciation: Leased Equipment 11,000
a. (112,635-2,635)/10 Accounting for Leases 117
Journal Entries for A4 (Payment in
Advance with BPO)-Lessee (contd.)
4. Recording accrued Interest Expense on 12/31/2015
Interest Expense 9,565.45a
Interest Payable 9565.45

a. (112,635.5-32,923.45) x 12%

5. 2nd annual payment in advance on 1/1/2016:


Lease Liability 23,358
Interest Payable 9,565.45
Property Tax Payable 3,000
Cash 35,923.45
Accounting for Leases 118
Journal Entries for A4 (Payment in
Advance with BPO)-Lessee (contd.)
6. Recording accrued Interest Expense on 12/31/2016
Interest Expense 6,762.49a
Interest Payable 6,762.49
a. (112,635.5 -32,923.45-23,358) * 12%

7. Third lease payment on 1/1/2017


Lease Liability 26,150.96
Interest Payable 6,762.49
Property Tax Payable 3,000
Cash 35,923.45

Accounting for Leases 119


Journal Entries for A4 (Payment in
Advance with BPO)-Lessee (contd.)
8. Recording accrued Interest Expense on 12/31/2017
Interest Expense 3,623.17a
Interest Payable 3,623.17
a. (112,635.5 -32,923.45-23,358-26,160.96) * 12%

9. fourth lease payment on 1/1/2018


Lease Liability 29,300.28
Interest Payable 3,623.17
Property Tax Payable 3,000
Cash 35,923.45

Accounting for Leases 120


Payments in Advance with BPO
(contd.)-Lessee
10. Recording accrued Interest on 12/31/2018:
Interest Expense 107.14 a
Interest Payable 107.14
a. (112,635.5 -32,923.45-23,358-26,160.96-29,300.28)x12%
On 1/1/2019, lessee exercises its BPO:
Interest Payable 107.14
Lease Liability 892.86
cash 1,000
Equipment 112,635 b
Leased Equip. 112,635
b. As of 1/1/2019, the accumulated depreciation of the equipment has a balance of $44,000
(annual depr. of 11,000 for 2015, 2016, 2017 and 2018).. The lessee will continue to recog.
$11,000 depr. Expense for the remaining economic life of the equipment..
Accounting for Leases 121
Journal Entries of Example A4
(Payment in Advance with BPO) -Lessor
1. Initial Recording
Lease Receivable 112,635.5a
Equipment 112,635.5
a. $32,923.45 x 3.401831+$1,000 x 0.6355 = PV of lease
payments + PV of BPO = cost = 112,635.5.

2. Payment on 1-1-2015 (at the inception of the lease)


Cash. 35,923.45
Lease Receivable 32,923.45
Property Tax Payable 3,000

Accounting for Leases 122


Journal Entries for A4 -Lessor
3. Recording accrued Interest revenue on 12/31/2015:
Interest Receivable 9,565.45a
Interest rev. 9,565.45
 Accrued int. = balance of Lease Liability x 12% = (112,635.5-
32,923.45) x 12% = interest expense of the lessee
4. Second lease payment on 1/1/2016:
Cash 35,923 .45
Lease Receivable 23,358
Interest receivable 9565.45
Property Tax Payable 3,000
 Accounting for Leases 123
Journal Entries for A4 -Lessor
5. Recording accrued Interest revenue on 12/31/2016:
Interest Receivable 6,762.49a
Interest rev. 6,762.49
 (112,635.5-32,923.45-23,358) x 12%
6. Third lease payment on 1/1/2017:
Cash 35,923 .45
Lease Receivable 26,160.96
Interest receivable 6,762.49
Property Tax Payable 3,000

Accounting for Leases 124


Journal Entries for A4 -Lessor
7. Recording accrued Interest revenue on 12/31/2017:
Interest Receivable 3,623.17a
Interest rev. 3,623.17
 (112,635.5-32,923.45-23,358-26,160.96) x12%
8. Fourth lease payment on 1/1/2018:
Cash 35,923 .45
Lease Receivable 29,300.28
Interest receivable 3,623.17
Property Tax Payable 3,000

Accounting for Leases 125
Journal Entries for A4 -Lessor
9. Recording accrued Interest revenue on
12/31/2018:
Interest Receivable 107.14 a
Interest rev. 107.14
 (112,635.5-32,923.45-23,358-26,160.96-29,300.28) x12%
10. Record the exercise of the BPO by the
lessee on 1/1/2019:
Cash 1,000
Interest Receivable 107.14
Lease Receivable 892.86
Accounting for Leases 126
BPO Is Exercisable before the End
of the lease Term
 For accounting purposes, the lease life
ends when the BPO becomes
exercisable.
 Therefore, the lease term needs to be
set to end when BPO becomes
exercisable.

Accounting for Leases 127


Lessors' Initial Direct Costs
 Initial direct costs include incremental and
internal.
Incremental direct costs are fees paid to

independent third parties for originating a lease


(e.g. the cost of appraisal of collateral used to secure a lease, the cost of
credit check, or a broker’s fee for finding the lessee).

Internal direct costs are related to activities


performed by the lessor on a given lease (e.g.
evaluating the prospective lessee’s financial condition, negotiating lease
terms, preparing and processing lease documents, and closing the
transaction, etc.

Accounting for Leases 128


Lessors' Initial Direct Costs (cont.)_
 Employees' compensation and
benefits associated with the time spent on
performing those activities should also be
included in as part of the direct costs.

 All other lease related costs (i.e., indirect


costs such as advertising, serving existing
leases, unsuccessful lease origination,
supervision and administration) are expensed
as incurred.
Accounting for Leases 129
Lessors' Initial Direct Costs (cont.)
 For an operating lease, initial direct costs are
recorded as a prepaid asset and are
allocated over the lease term as operating
expense in proportion to the rental revenue.

Accounting for Leases 130


Lessors' Initial Direct Costs (cont.)_
 For a capital lease
 a. a direct-financing lease: these costs are
deferred and allocated over the lease
term (to match with interest revenue
recognized over the lease term).
 b. a sales type lease: these costs are
expensed at the inception of the lease
because sales revenue is recognized at
the inception.

Accounting for Leases 131


Lessors' Initial Direct Costs (cont.)_
 Assuming the lessor incurred $5,000 of initial
direct costs on a direct financing lease, it will
record the costs as follows:
 Lease Receivable
a 5,000
Cash (or A/P) 5,000
a. See p1225 of the textbook for details (16th edition)
 The lessor needs to determine a new implicit
rate that will discount the future lease payments
to the new net investments (i.e., the revised
lease receivable) as of the inception of the
lease. Accounting for Leases 132
Lessors' Initial Direct Costs (cont.)_
 Consequence: The additional $5,000 lease
receivable will decrease the implicit interest
rate since the lease payments remain
unchanged(e.g. $32,923.45 as in previous
examples).
The lower rate would result in less interest

revenue recognition each period and achieve


the goal of deferring direct costs and
including them as a reduction of income over
the life of the lease.
Accounting for Leases 133
Sales-Type Leases (for lessor)
 The major differences between a sales-
type lease and a direct financing lease are:

a. the presence of a manufacturer's or


dealer's profit or loss in a sales-type
lease, and
b. the accounting for initial direct costs.

Accounting for Leases 134


Sales-Type Leases (lessor)
 The manufacturer's or dealer's profit is
measured as the difference between
(1) the present value of the MLP (net of
executory costs), and
2) the cost or carrying value of the asset
plus the initial direct costs less the PV of the
unguaranteed residual value accruing to the
benefit of the lessor.

Accounting for Leases 135


Sales-Type Leases (lessor):(contd.)
 The accounting treatment for a sales-type
lease is the same as for a direct financing
lease except for recognizing the profit at the
inception of the lease.

 Example B1: on 1/1/2015, the York Company


(the lessor) leases an equipment to the Lake
Company (the lessee) with the terms and
provisions as stated on the following:

Accounting for Leases 136


Example for Sales-type Leases (Lessor)
1.The cost of the equipment is $120,000. The
fair market value is $190,008.49.
2.No initial direct costs are incurred by the York
Company.
3.The Lake Company is given an option to buy the
equipment at the end of the lease term at $500.
4.The term of the lease is 10 Years, with annual
payments of $30,000* received at the beginning of
each year. The estimated economic life of the
equipment is also 10 years.
*Lessor's computation of the lease payment: (190,008 - PV of
BPO $500)/6.3283 = 30,000

Accounting for Leases 137


Sales-type Leases (Lessor)
5.The Lake Company agrees to absorb all
executory costs.
6.The interest rate implicit in the lease is 12%.
7.The present value of 10 payments of $30,000
at 12% on an annuity basis plus the present
value of the bargain purchase option is
$190,008.49,calculated as follows:

Accounting for Leases 138


Sales-type Leases (Lessor)
Present value of 10 rents in
advance at 12% (6.3283 * $30,000) = 189,847.50
Plus: Present value of $500
discounted at 12% (0.321973 * $500) = 160.99
Total present value = $190,008.49

8.The collectibility of the payment is reasonably


assured, and there are no uncertainties involved
in the lease.

Accounting for Leases 139


Application of criteria for determination of lease
classification by York company (lessor)
Classification Criteria Criteria Remarks
Met?
Group I No
1. Transfer of ownership Yes
2. Bargain purchase option Yes
3. Lease term is 75% of Yes 100% of life
economic life
4. Present value of lease Yes The present value is
payments is 90% of fair $190,008.49, or 100%
value of estimated fair value
Group II
1. Collectibility reasonably Yes
assured
2. No uncertianties Yes

Accounting for Leases 140


Application of criteria for determination of lease
classification by York company (lessor):(contd.)

Conclusion: The lease is a sales-type


lease. Since appropriate criteria are met
and there is a manufacturer's or dealer's
profit.
 The amount used as the selling price
($190,008.49) exceeds the cost ($120,000).
That is, the present (fair) value of the lease
payments is greater than the cost of the
property.

Accounting for Leases 141


Journal Entries for Sales-type Leases
(Lessor)
 Assuming that the York Company (the lessor)
uses the perpetual Inventory system. it
records the information relevant to the lease
as follows:
1.Initial Recording of the sales-Type lease
on 1/1/2015:
Lease Receivable 190,008.49
Cost of Goods Sold 120,000
Sales Revenue a 190,008.49
Equipment Held for Lease 120,000
a. Sales revenue=PV of lessee's MLP = fair value of leased
assets if all R.V. is guaranteed.

Accounting for Leases 142


Journal Entries for Sales-type Leases
(Lessor) (Contd.)
 If portion of the RV is unguaranteed,
both the cost of goods sold and the
sales revenue accounts will be
reduced by the PV of the unguaranteed
RV.
 The unguaranteed RV is treated as the
portion of the asset which is not sold.

Accounting for Leases 143


Journal Entries for Sales-type Leases
(Lessor) (Contd.)
2.Collection of the 1st lease payment on 1/1/2015:
Cash 30,000
Lease Receivable 30,000
3. Recognition of interest revenue on 12/31/2015:
Interest Receivable 19,201.02*
Interest Revenue 19,201.02
* (190,008.49 - 30,000) x 12%
4. Collection of the 2nd lease payment on 1/1/2016:
Cash 30,000
Lease Receivable 10,798.98
Interest Receivable 19,201.02

Accounting for Leases 144


Journal Entries for Sales-type Leases
(Lessor) (Contd.)
5. Recognition of interest revenue on 12/31/2016:
Interest Receivable 17,905.14*
Interest Revenue 17,905.14
* (190,008.49 - 30,000 – 19,201.12) x 12%
6. Collection of the 3nd lease payment on 1/1/2017:
Cash 30,000
Lease Receivable 12,094.86
Interest Receivable 17,905.14

Accounting for Leases 145


Journal Entries forSales-type Leases
(Lessor) (Contd.)
The journal entries for the next 7 years
for the lessor will follow the similar pattern to
the entries of 2016 and 2017.
After the 10
th lease payment on 1/1/2024, the

balance of the lease receivable is $446.46 (see


the summary table on p148).

Accounting for Leases 146


Journal Entries forSales-type Leases
(Lessor) (Contd.)
 The following entry is recorded on 12/31/2024:
Interest Receivable 53.54 a
Interest Revenue 53.54
a. 446.46 x 0.12
 When the BPO is exercised by the lessee, the
following entry is recorded:
Cash 500
Lease Receivable 446.46
Interest Receivable 53.54

Accounting for Leases 147


Summary for Sale-Type Leases
(1) (2) (3) (4) (5)
Annual Lease Int. Rece./Int. Rev. Lease Receivable
Date Payment Received (12% * Bal. of LR) Reduction of LR (LR)
1/1/2015 - - 190,008.49
1/1/2015 30,000 - 30,000 160,008.49
12/31/2015 - 19,201.02 - -
1/1/2016 30,000 - 10,798.98 149,209.51
12/31/2016 - 17,905.14 - -
1/1/2017 30,000 - 12,094.86 137,114.65
12/31/2017 - 16,453.76 - -
1/1/2018 30,000 - 13,546.24 123,568.41
12/31/2018 - 14,828.21 - -
1/1/2019 30,000 - 15,171.79 108,396.62
12/31/2019 - 13,007.59 - -
1/1/2020 30,000 - 16,992.41 91,404.21
12/31/2020 - 10,968.51 - -
1/1/2021 30,000 - 19,031.49 72,372.72
12/31/2021 - 8,684.73 - -
1/1/2022 30,000 - 21,315.27 51,057.45
12/31/2022 - 6,126.89 - -
1/1/2023 30,000 - 23,873.11 27,184.34
12/31/2023 - 3,262.12 - -
1/1/2024 30,000 - 26,737.88 446.46
12/31/2024 - 53.57 - -
Accounting for Leases 148
Other Comments Related to Sales-Type Leases

 The lessor does not record any


depreciation on the leased asset since a
sale is deemed to have taken place
(due to BPO price is so low).

 The lessee will depreciate the leased


asset and pay for the executory costs.

Accounting for Leases 149


Other Comments (contd.)

 Initial Direct Costs (IRD) Involved in a Sales-


Type Lease:
The IRD under the sales-Type lease should
be expensed at time of occurrence in order
to match with the revenue recognition at the
inception of the lease.

 This can be done by including these costs in


the cost of goods sold or as a selling
expense.
Accounting for Leases 150
Reporting on Statement of Cash Flows
Operating Leases: both lessee and lessor
report cash flows related to lease payments
as cash flows from operating activities.

Capital Leases:
Lessee: reports cash flows for payments
toward interest exp. as cash flows from
operating activities and reports the payments
toward the principal (i.e., Lease Liability) as
cash flows from financing activities.
Accounting for Leases 151
Reporting on Statement of Cash Flows
(contd.)
Capital Leases (contd.):
Lessor: reports cash flows of the interest
portion as cash flows from operating
activities and the cash receipts toward the
principal portion as cash flows from
investing activities.

Accounting for Leases 152


Contingent Rentals
 Lease payments may be increased if a
future event occurs (i.e., an increase of
revenue over 30%; or an increase of usage
on the leased property).
 The potential incremental lease payments
are referred to as contingent rentals.
 Contingent rentals are not included in the
MLP because they are not determinable at
the inception of the lease.

Accounting for Leases 153


Contingent Rentals (contd.)
 Contingent rentals are included in income
when they occur.
 However, any contingent lease payments
depending only on the passage of time are
included in the MLP.

Accounting for Leases 154


Lease Disclosures
 A general description of the leasing
arrangement.
 Minimum future payments in the
aggregate and for each of the five
succeeding year.
 Residual values.
 Contingent rentals.
 Unearned interest.
 Sublease rentals.
 Executory costs.

Accounting for Leases 155


Sale and Leaseback Arrangements
(skip 155 - 166)
 The owner of an asset sells and leases the
asset back from the new owner
immediately.

 Possible Reasons: 1) to generate cash; 2)


to refinance the asset at a lower interest
rate when the interest rate is declining.

Accounting for Leases 156


Gains and Losses for a Sale-
Leaseback (skip)
 Gains on the sale of the asset in a sales-
leaseback transaction is deferred and
amortized (i.e., to offset with the depreciation
expense (rental expense) of the leased
asset in a capital (an operating) lease).
 A loss on the sale of the asset, however, is
recognized immediately.

Accounting for Leases 157


Sale and Leaseback: Example (capital lease
for the lessee) (skip)
 Clear Water Corp. was in need of cash. To
solve the problem, it sold its two
equipments for $700,000, then lease back
the equipments for its continuous usage.
The equipments had a carrying value on
Clear Water’s books of $520,000 (original
cost $720,000). The sale date is
1/1/2007.Other information:
 1. The noncancelable lease term is 10
years and requires the annual payments of
$103,566 beginning 1/1/2007.
Accounting for Leases 158
Sale and Leaseback: An Example
(contd.) (skip)
2. The estimated remaining useful life of the
warehouses is 10 years.
3. The implicit interest of the lessor and the
incremental borrowing rate of the lessee
are 10%.
4. No residual value was expected and a
straight-line depreciation method is used by
Clear Water.

Accounting for Leases 159


Sale and Leaseback: An Example (Contd.)-
Capital lease for Lessee (skip)
1/1/2007 (capital lease for lessee)
Cash 700,000
Acc. Depr. 200,000
Equipment 720,000
Deferred Gain on Sale-leaseback 180,000

Leased Equip. 700,000


Lease Liability 700,000
(PV of MLP= 103,566x6.759)
Lease Liability 103,566
 Cash 103,566
Accounting for Leases 160
Sale and Leaseback: example
(contd.) (skip)
 12/31/2007
 Interest Expense 59,643
 Interest Payable 59,643
 Depreciation expense 70,000
 Accu. Depreciation 70,000
 Deferred Gain 18,000
 Depreciation Expense 18,000
 Note: if this is an operating lease, the deferred gain
is used to offset the rent expense.
Accounting for Leases 161
Sale and leaseback: An Example
(contd.) (skip)
1/1/2008
Interest Payable 59,643
Lease Liability 43,923
Cash 103,566

Accounting for Leases 162


Real Estate Leases (skip)
 Leases of Land only:
 Due to the unlimited life of land, the 75% rule
and 90% test will not apply to land in
determining the lease type.
 Therefore, only if criteria a (ownership
transfer) or b (with BPO) is met, a lease of
land will be reported as a capital lease
 Under the capital lease reporting, no
depreciation for land is recognized.
Accounting for Leases 163
Real Estate Leases (condt.) (skip)
 Lease of Land and Building:
 1) Either criterion a or b is met, the lease of
land and building will be recorded separately
and the MLP of the lease would be
allocated between the land and building
based on their separate relative market
values.
 2)Neither criterion a nor b is met:
 a. the market value of land is equal or less
than 25% of the combined fair value =>
Accounting for Leases 164
Real Estate Leases (condt.) (skip)
the lease is treated as a lease of
building only and therefore, both land
and building will be depreciated by the
lessee when it is reported as a capital
lease.
 b. the market value of land is more than
25% of combined value: the lease will
be treated as a lease of land and a
lease of building.
 . Accounting for Leases 165
Real Estate Lease (contd.) (skip)
 The classification of the lease type of
the building is similar to the criteria
described earlier and the land is an
operating lease.

Accounting for Leases 166


Leveraged Leases (skip)
 A third party (i.e., a creditor) provides
financing for a lease agreement between a
lessor and a lessee.
 The lessor relies heavily on borrowing to buy
the leased assets.
 The liability of the lessor would be offset
against the lease receivable.
 Payments from the lessee are applied to the
note payable to the creditor.
Accounting for Leases 167
Why Does FASB Issue ASU2016-2 to
Amend ASC 842 : Leases
 On 2/25/2016, the FASB issued ASU2016-2
which was added to ASC 842: Leases.
 Reasons of issuing ASU2016-2: to improve
the representation faithfulness of lease
transactions.
 From a lessee point of view, both capital and
operating leases represent acquiring the
right to use leased assets.

Accounting for Leases 168


ASU 2016-2 (contd.)
 However, a capital lease reports a leased
asset and lease liability on the balance sheet
while the operating lease does not.
 Thus, two similar economic transactions
(i.e., acquiring the right to use assets) are
reported very differently on the balance
sheet.
 ASU 2016-2 (amends ASC 842) aims to
improve the presentation of lease
transactions.
Accounting for Leases 169
The Effective Date of ASU 2016-2
 For public companies, the effective date of
ASU 2016 -2 is for fiscal periods beginning
after December 15, 2018.
 For a December fiscal-year-end firm, the first
fiscal year to apply ASU2016-2 is for its
2019 annual report.
 Until then, the current accounting standards
for leases still apply.

Accounting for Leases 170


ASU 2016-2
 Under ASU2016 -2, leases are categorized into
finance and operating leases.
 Finance Leases: lease transfers substantially all
the risks and rewards of ownership of the
underlying asset. In this case, the lessee takes
ownership of the underlying assets over the
lease term.
 Operating Leases: The lease does not transfer
substantially all the risks and rewards of
ownership. A lessee obtains the right to use the
underlying asset. .Accounting for Leases 171
Lease Classification Tests for Finance vs.
Operating Leases (illustation 21A-2)

Accounting for Leases 172


Balance Sheet Reporting for
Lessees
 Regardless a finance lease or an operating
lease, the lessee records leased asset and
lease liability on the balance sheet as follow:
Right-of-use asset xxx
Lease liability xxx
 Comment: no differential treatment in reporting leases
on the balance sheet and therefore, eliminate the off-
balance sheet financing of reporting leases as
operating leases as in the existing standards.

Accounting for Leases 173


Income Statement Reporting for
Lessees
 Finance lease: the lease expenses include the
interest expense on the lease liability and the
depreciation expense of the leased assets (based
on the straight-line method as in the capital leases).

 Operating lease: the lease expenses equal the


annual lease payments and are reported in two
accounts: 1)interest expense on lease liability,
and 2)amortization expense (a plug in number
equals the annual lease payment minus the interest
expense).

The Accounting for Leases 174


Income Statement Reporting for Lessees
(contd.)
 Comments:
 The lease expenses of finance lease
leases are similar to the capital lease
expenses while those of operating lease
are similar to the operating lease
expenses under the current standards.
FASB improves the lease reporting for the
balance sheet but not for the income
statement.
Accounting for Leases 175
Balance Sheet Reporting for Lessors
(similar to the existing standards)
Finance lease:
Lease Receivable xxx
Asset xxx
Profit* (if any) xxx
* If the lease receivable exceeds the asset’s book value
(cost) and “control” of the asset is transferred to the lessee
(if control is not transferred, the profit will be deferred).
 Operating lease:
Continue to carry asset on books (no entry)

Accounting for Leases 176


Income Statement Reporting for
Lessors(similar to the existing standard)
 Finance lease:
Interest revenue on remaining lease
receivable based on the implicit interest
rate of the lessor
No amortization expense
 Operating lease:
Straight-line lease revenue (equals the
annual lease payment)
Amortization expense (over the eco. Life of the asset)
Accounting for Leases 177
Summary Table for ASU2016-2
Balance Sheet Income Statement


Lessee
Finance
Risks and
rewards of
Right-of-use asset xxx
lease liability xxx
1. Int. expense on liability

Lease ownership 2. Amortization expense on


transfer assets (over the lease term)
Lessee Risks and Right-of-use asset xxx lease expense = annual lease payment =
Operat- rewards of lease liability xxx 1. Int. expense on lia.
ing ownership 2. Amort. Exp. = (annual lease
lease do not payment – int. expense on
transfer lia.) (a plug-in number)
Lessor Lease receivable xxx 1. Interest revenue (on
Finance Asset xxx receivable)
lease Profit (if any) xxx 2. No amort. Expense

Lessor Continue to carry asset on 1. Straight-line lease revenue =


Operat- books (no entry) lease payments
ing 2. Depreciation expense (over
lease the eco. Life of the asset) on
Accounting for Leases assets 178
Example C1: Lease Classification under ASU 2016-2 (This
example is the same as Example A2 (p82-83) but applying
ASU2016-2)
Equipment is leased under an agreement without
a transfer of ownership, a bargain purchase option
or a guaranteed RV.

Terms and provisions of lease agreement


between Kingston company (lessor) and Johnson
company (lessee) dated January 1,2015:

The lease term is 4 years. The lease is


noncancelable and requires equal payments of
$35,923.45 (including $3,000 executory cost) at
the beginning of each year.
Accounting for Leases 179
ASU2016-2: Example C1 (contd.)
2. The cost, and also fair value, of the equipment
to Kingston (lessor) at the inception of the lease
is $112,000.
3. The equipment has an estimated economic life
of 4 years and has a zero estimated residual
value at the end of lease term.
4. There is no guarantee of the residual value
by the Johnson Company.
5. Johnson (lessee) pays all executory costs
directly to third parties except for the property
taxes of $3,000 per year, which is included as
part of tis annual payments to Kingston(lessor).
Accounting for Leases 180
ASU2016-2: Example C1 (contd.)
6. Johnson’s (lessee) incremental borrowing
rate is 12.5% per year.
7. Kingston's (lessor)implicit interest rate is
12%. Johnson Company knows this rate.
8. The annual lease payment charged by the
lessor is calculated as follow:
$1120,000 / 3.401831 a = $32,923.45
 Since Johnson is responsible for all executory costs,
Johnson would pay $35,923.45 to Kingston each year to
cover $32,923.45 lease payment and $3,000 property tax..
a. P.V. factor of an annuity due of $1 for 4 periods at 12%
interest rate.
Accounting for Leases 181
ASU2016-2: Example C1 (Contd.)
9. The equipment reverts to Kingston at the
end of the 4 years.
10.Johnson Company uses the straight-line
method to record depreciation on similar
equipment's.
11.The collectiblity of rental is reasonably
assured and no uncertainties involved in
the lease;
12. No initial direct costs.

Accounting for Leases 182


Application of criteria to determine the lease
classification
Classification Criteria Criteria Met? Remarks
1. Transfer of ownership at end of lease No Title reverts
to lessor
2. Bargain purchase option No
3. Leas term is 75% or more of economic life Yes 100% of
estimated life
4. Present value of MLP is 90% or more
of fair value Yes The Present
value is
$100,000, or
100% of fair
value

Accounting for Leases 183


Application of criteria to determine the
lease classification under ASU 2016-2
The lease is a finance lease for the lessee
because it transfers substantially all the risks and
rewards of ownership of the underlying asset to
the lessee (evidence from meeting criteria 3 (lease
term test) and 4 (present value test ) on P171).
The lease is also a finance lease and a direct

financing lease for the lessor because:


1. It meets the lease term and the present value

tests on P171.
2. No dealer or manufacturer’s profit.

Accounting for Leases 184


ASU2016-2: The Accounting Treatment for
finance lease leases
 For both lessees and lessors, the accounting is
similar to that of capital leases under the current
lease standards.
For the lessee’s journal entries, see p84-89.

For the lessor’s journal entries, see p90-93.

For lessee’s entries, replace leased equipment

with right-of-use (ROU) asset, deprecation


expense with amortization expense and
accumulated depreciation with ROU asset (i.e., a
direct write-off for the ROU asset via
amortization). Accounting for Leases 185
Example C2: Lease Classification under ASU 2016-2
(This example is the same as the lease example on
p35-36 but applying ASU2016-2)
Terms and provisions of lease agreement between
landlord company (lessor) and tenant company
(lessee) dated January 1, 2015
1.The lease term is 5 years. The lease is
noncancelable and requires equal rental payments
of $50,000 at the beginning of each year.
2.The cost, and also fair value, of the equipment to
the Landlord Company at the inception of the lease
is$400,000. The equipment has an estimated
economic life of 10 years and has a zero estimated
residual value at the end of this time.

Accounting for Leases 186


ASU2016-2: Example C2 (contd.)
3.There is no guarantee of the residual value by the
Tenant Company.
4.The Landlord Company agrees to pay all executory
costs.
5.The equipment reverts to the Landlord Company at
the end of the 5 years;
6.The Tenant Company's incremental borrowing rate
is 12.5% per year.
7.For the Landlord Company, the interest rate implicit
in the lease is 12%.
8.The present value of an annuity due of 5 payments
of $50,000 each at 12% is 4.037349 * $50,000 =
$201,867.45
Accounting for Leases 187
Application of Criteria for Determination
of Lease Classification
Classification Criteria Criteria Met? Remarks
1. Transfer of ownership at end of lease No
2. Bargain purchase option No
3. Lease term is 75% of economic life No It is 50%
4. Present value of lease payments is 90%
of fair value No The present
value is
$201,867.45,
or 50.5% of fair
value
Conclusion: the lease is an operating lease because
the lease does not transfer substantially all the risks
and rewards of ownership of the underlying asset to the
lessee. Accounting for Leases 188
ASU2016-2: Journal Entries for
Example C2- Lessee
 Initial Recording
Right-of-Use (ROU) Asset 201,867.45
Lease Liability 201,867.45
 Payment on 1-1-2015
Lease Liability 50,000
Cash 50,000
Recording the accrued Interest and amortization expense on 12/31/2015:
Interest Expense 18,224.09 a
Amortization Expense 31,775.91b
Interest Payablec 18,224.09
ROU Assetd 31,775.91
a. (201,867.45 -50,000) * 12%; b. A plug-in number (50,000-18,224.09)
c. An alternative account is lease liability; an alternative account is accumulated
amortization Accounting for Leases 189
ASU2016-2: Journal Entries for
Example C2- Lessee
An Alternative Recording on 12/31/2015:

Lease Expense 50,000a

Interest Payable 18,224.09


ROU Assetd 31,775.91

a. Lease expense = Interest expense + amortization expense or


(18,224.09+31,775.91) in which 31,775.91 is a plug in number to
equate the lease expense to the annual lease payment of
$50,000

Accounting for Leases 190


ASU2016-2: Example C2- Lessee
(contd.)
 Second lease payment on 1/1/2016:
Lease Liability 31,775.91
Interest Payable 18,224.09
Cash 50,000
 Record accrual interest and amort. expense on 12/31/2016
Interest Expense 14,410.98a
Amortization Expense 35,589.02b
Interest Payable 14,410.98
ROU Asset 35,589.02
a. (201,867.45 -50,000 -31,775.91) x 12%; b. A plug-in number (50,000 – 14,410.98)
 An Alternative Recording on 12/31/2016:
Lease Expense 50,000
Interest Payable 14,410.98
ROU Asset 35,589.02
Accounting for Leases 191
ASU2016-2: Example C2- Lessee
(contd.)
 Third lease payment on 1/1/2017:
Lease Liability 35,589.02
Interest Payable 14,410.98
Cash 50,000
 Record accrual interest and amort. expense on 12/31/2017
Interest Expense 10,140.3a
Amortization Expense 39,859.7b
Interest Payable 10,140.3
ROU Asset 39,859.7
a. (201,867.45 -50,000 -31,775.91-35,589.02) x 12%; b. A plug-in number (50,000 – 10,140.3)
 An Alternative Recording on 12/31/2017:
Lease Expense 50,000
Interest Payable 10140.3
ROU Asset 39,859.7
Accounting for Leases 192
Example C2 –Lessee (Cont.)
 Fourth payment on 1/1/2018:
Lease Liability 39,859.7
Interest Payable 10,140.3
Cash 50,000
Record accrual interest and amort. expense on 12/31/2018
Interest Expense 5,357.14a
Amortization Expense 44,642.86b
Interest Payable 5,357.14
ROU Asset 44,642.86
a. (201,867.45 -50,000 -31,775.91-35,589.02-39,859.7) x 12%; b. A plug-in
number (50,000 – 5,357.14)
An Alternative Recording on 12/31/2018:
Lease Expense 50,000
Interest Payable 5,357.14
ROU Asset Accounting for Leases
44,642.86 193
Example C2 –Lessee (Cont.)
 Record the Fifth payment on 1/1/2019:
Lease Liability 44,642.86
Interest Payable 5,357.14
Cash 50,000
Record accrual interest and amort. expense on 12/31/2019
Interest Expense 0a
Amortization Expense 50,000b
Interest Payable 0
ROU Asset 50,000c
a. The lease liability account balance on 1/1/2019 is zero to result in zero interest
expense for 2019;(201,867.45 -50,000 -31,775.91-35,589.02-39,859.7-44,642.86) =0
(see table on p194) b. A plug-in number (50,000 – 0); c. ROU asset account balance on
12/31/2019 is zero.

An Alternative Recording on 12/31/2019:


Lease Expense 50,000 Accounting for Leases 194
Lessee’s Summary Table of Example C2
(An operating lease Lease)
 Date Annual Lease
payment
Accrued Interest
at 12% of the
Reduction of
Lease
Balance of
Lease
balance of Lease
Liability Liability Liability
1/1/2015 $201,867.45
1/1/2015 $50,000 $0 $50,000 $151,867.45
12/31/2015 $18,224.09
1/1/2016 $50,000 $31,775.91 $120,091.54
12/31/2016 $14,410.98
1/1/2017 $50,000 $35,589.02 $ 84,502.52
12/31/2017 $10,140.3
1/1/2018 $50,000 $39,859.7 $ 44,642.82
12/31/2018 $5,357.14
1/1/2019 $50,000 $44,642.86 $0

Accounting for Leases 195


ASU2016-2: Journal Entries for Example C2-
Lessor
 Initial Recording
No entry to record receivable or to derecognize asset
as in a finance lease lease
 Receive the 1st lease payment on 1-1-2015
Cash 50,000
Unearned Lease Revenue* 50,000
* When the $50,000 is received on 1/1/2015, it is not yet earned.
Record the lease revenue and the depr. exp. on12/31/2015:
Unearned Lease Revenue 50,000
Lease Revenue 50,000
Depreciation Expense* 40,000
Acc. Depr. 40,000
* $400,000 cost /10 years Accounting for Leases 196
Example C2 –Lessor (contd.)
 Receive the 2nd lease payment on 1-1-2016
Cash 50,000
Deferred Revenue* 50,000
 Record the lease revenue and the depr. exp.
on12/31/2016:
Deferred Revenue 50,000
Lease Revenue 50,000
Depreciation Expense* 40,000
Acc. Depr. 40,000
 Similar entries as in 2/2/2016 and 12/31/2016 will
be recorded on 1/1/2017,12/31/2017, 1/1/2018,
12/31/2018, 1/1/2019 and 12/31/2019.
Accounting for Leases 197