CHAPTER 21

ACCOUNTING FOR LEASES

ACCT5170
Corporate Financial Accounting II
Shiheng Wang@ HKUST

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 Learning Objectives

1. Describe the environment related to leasing transactions.

2. Explain common leasing terminologies.
3. General principles of lease accounting for the lessee.
4. General principles of lease accounting for the lessor.

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 INTRODUCTION

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 Lease

A lease is a contractual agreement between a lessor and a

lessee, that gives the lessee the right to use specific property,
owned by the lessor, for a specified period of time. In return
for the use of the property, the lessee makes rental payments
over the lease term to the lessor.
Largest group of leased equipment involves:
 Information technology
 Transportation (trucks, aircraft, rail)
 Construction
 Agriculture

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 Lease Terminologies

Lease term: the time period from the beginning to the end of the lease.

Guaranteed residual value (GRV): estimated fair value of the leased

property at the end of lease term that is guaranteed by the lessee, a
party related to the lessee, or a third party. If, at the end of the lease
term, the actual fair value is below the GRV, the guarantor has to
pay the difference to the lessor.

Un-guaranteed residual value: estimated fair value of the leased

property at the end of lease term that is not guaranteed by any
party. This value is used by the lessor only.

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 Lease Terminologies
Bargain purchase option (BPO): a lease that allows the lessee
the right (option) to purchase the property at a price that is
considerably less than the fair value, so that exercise of
the right is virtually certain.

Executory costs: charges for insurance, maintenance, and taxes

on the leased property.

Initial direct costs: costs incurred (normally by the lessor) on

setting up the lease, including costs to negotiate the
lease, perform the credit check on the lessee, and prepare
the lease documents.

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 Lease Terminologies
(Lessor’s) Implicit interest rate: the rate that makes the
aggregate present value of lease payments and unguaranteed
residual value equal to the fair market value of the leased asset at
the beginning of the lease.

(Lessee’s) Incremental borrowing rate: the interest rate that the

lessee could use to borrow the amount of money necessary to
purchase the leased asset.

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 Lease Accounting For Lessee

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 Lessee Accounting-General Principles

IASB requires lessees to capitalize all leases.

Only exceptions:
 leases covering a term of less than one year or
 lease of property with a value less than $5,000.

Right-to-use property under the lease is an

 asset, and
 lessee’s obligation to make payments is a liability.

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 Lessee Accounting-General Principles

The lessee
 recognizes interest expense on the lease liability using the
effective-interest method and
 records depreciation expense on the right-of-use asset.

This accounting (finance lease) is applied whether the lease is

effectively
 a purchase of the asset or
 when the lessee only controls the use of the asset.

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 Lessee Accounting-General Principles

Lease Term

 The fixed, non-cancelable term of the lease.

 Bargain-renewal option can extend this period.

At the commencement of the lease, the difference between the

renewal rental and the expected fair rental must be great enough to
make exercise of the option to renew reasonably certain.

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 Lessee Accounting-General Principles

Illustration: Carrefour (FRA) leases Lenovo (CHN) PCs for two

years at a rental of $100 per month per computer and subsequently
can lease them for $10 per month per computer for another two
years. The lease clearly offers a bargain-renewal option; the lease
term is considered to be four years.

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 Lessee Accounting-General Principles

Lease Payments

 Fixed payments.
 Variable payments that are based on an index or a rate.
 Guaranteed residual value.
 Payments related to purchase or termination options that the
lessee is reasonably certain to exercise (e.g., bargain-
repurchase option).

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 Lessee Accounting: Example 1
Illustration: assume that CNH Capital and Ivanhoe Mines Ltd. sign a lease agreement
dated January 1, 2022, that calls for CNH to lease a backhoe to Ivanhoe beginning
January 1, 2022.
• The term of the lease is five years. The lease agreement is non-cancelable, requiring
equal rental payments of €20,711.11 at the beginning of each year (annuity-due
basis).
• The backhoe has a fair value at the commencement of the lease of €100,000, an
estimated economic life of five years, and a guaranteed residual value of €5,000.
(Ivanhoe expects that it is probable that the expected value of the residual value at
the end of the lease will be greater than the guaranteed amount of €5,000.)
• The lease contains no renewal options. The backhoe reverts to CNH Capital at the
termination of the lease.
• Ivanhoe’s incremental borrowing rate is 5 percent per year.
• Ivanhoe depreciates its equipment on a straight-line basis.
• CNH sets the annual rental rate to earn a rate of return of 4 percent per year;
Ivanhoe is aware of this rate.
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 Lessee Accounting: Example 1

Ivanhoe computes the lease liability and the amount capitalized as a

right-of-use asset as follows:

Payment € 20,711.11
Present value factor (i=4%,n=5) x 4.62990
PV of lease payments €95,890.35

Ivanhoe uses CNH's implicit interest rate of 4 percent instead of its

incremental borrowing rate of 5 percent because it is known to
Ivanhoe.

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 Lessee Accounting: Example 1

Ivanhoe records the finance lease on its books on January 1, 2022,

as:

Right-of-Use Asset 95,890.35

Lease Liability 95,890.35

Ivanhoe records the first lease payment on January 1, 2022, as

follows.

Lease Liability 20,711.11

Cash 20,711.11

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 Prepare the entry to record accrued interest at Dec. 31, 2022.

Interest Expense 3,007.17

Lease Liability 3,007.14
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 Lessee Accounting: Example 1

Depreciation of the right-of-use asset over the five-year lease term,

applying Ivanhoe’s normal depreciation policy (straight-line method),
results in the following entry at December 31, 2022.

Depreciation Expense 19,178.07

Right-of-Use Asset (€95,890.35 ÷ 5 years)

19,178.07

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 Lessee Accounting: Example 1
The statement of financial position as it relates to lease transactions at December 31,
2022.

On its December 31, 2022, income statement, Ivanhoe reports,

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 Lessee Accounting: Example 1

Ivanhoe records the second lease payment as follows.

Lease Liability (€3,007.17 + €17,703.95) 20,711.11

Cash 20,711.11

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 Lessee Accounting: Example 1

If Ivanhoe purchases the equipment from CNH at the termination of

the lease at a price of €5,000 and the estimated remaining life of the
equipment is two years, it makes the following entry on January 1,
2027.
Equipment 5,000

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Cash 5,000
 Lessee Accounting: Example 2

Illustration - guaranteed residual value

Assume a situation where the expected residual value is below the

guaranteed residual value, assume in the earlier CNH/Ivanhoe
example that it is probable that the residual value will be €3,000
instead of the guaranteed amount of €5,000. If Ivanhoe estimates
the residual value of the backhoe at the end of the lease to be
€3,000, Ivanhoe includes €2,000 (€5,000 − €3,000) as an additional
lease payment in determining the lease liability and right-of-use
asset.

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 Lessee Accounting: Example 2

Ivanhoe computes the lease liability and the amount capitalized as a

right-of-use asset as follows:

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 Lessee Accounting: Example 2
Ivanhoe makes the following entries to record the lease and the first
payment on January 1, 2022, as:

Right-of-Use Asset 97,534.21

Lease Liability 97,534.21

Lease Liability 20,711.11

Cash 20,711.11

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 Lessee Accounting: Example 2

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 Lessee Accounting: Example 2

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 Lessee Accounting: Example 2

Assume that due to poor maintenance of the backhoe, Ivanhoe and

CNH agree that the fair value of the asset is zero upon returning the
backhoe to CNH on January 1, 2027. In this case, Ivanhoe reports a
loss of €3,000. Under the expected payment scenario, Ivanhoe
makes the following entry.

Loss on Lease (€5,000 − €2,000) 3,000

Cash 3,000

Under the no expected payment scenario, Ivanhoe makes the

following entry.

Loss on Lease (€5,000 − €0) 5,000

Cash 5,000
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 Lessee Accounting: Example 2

Bargain purchase option allows the lessee to purchase the leased

property for a future price that is substantially lower than the asset’s
expected future fair value.

 Lessee must increase the present value of the lease

payments by the present value of the option price.

 Affects the accounting in the same way as a guaranteed

residual value with a probable amount to be owed.

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 Lessee Accounting: Example 3
Unguaranteed Residual Value: Assume that Hathaway Disposal (lessor)
and Marks and Spencer plc (M&S) (GBR) (the lessee) sign a lease
agreement dated January 1, 2022. The lease agreement specifies that
Hathaway will grant right-of-use of one of its standard cardboard compactors
for use at one of M&S’s stores. Information relevant to the lease is as follows.
 Lease term is three years, non-cancelable, requires rental payments
of £17,620.08 at the beginning of each year.
 Compactor has a cost and fair value at commencement of the lease of
£60,000, an estimated economic life of seven years, and an expected
residual value of £12,000, which is unguaranteed.
 Lease contains no renewal options, the compactor reverts to
Hathaway at the termination of the lease.
 Implicit rate of the lessor is not known by M&S. M&S’s incremental
borrowing rate is 6 percent.
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 Lessee Accounting: Example 3
The present value of the lease payments for M&S in this situation is
£49,924.56 (£17,620.08 × 2.83339 (PVF-AD(3,6%)).
The lease liability of £49,924.56 does not include any payments
related to the unguaranteed residual value.
M&S makes the following entries.

January 1, 2022
Right-of-Use Asset 49,924.56
Lease Liability 49,924.56

Lease Liability 17,620.08

Cash 17,620.08

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 Lessee Accounting: Example 3

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 Lessee Accounting: Example 3

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 Low-Value and Short-Term lease

IASB provided an exception to required capitalization of all leases:

1. Low-Value Leases (underlying assets with values of $5,000 or

less), lessee may elect to expense lease payments as
incurred.

2. Short-Term Leases (lease term of 12 months or less), lessee

may elect to expense lease payments as incurred.

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 Lease Accounting For Lessor

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 Lessor Accounting

Economics of Leasing

Lessor determines the amount of the rental payment, not the lessee.
 Determines payment using rate of return (implicit rate).
 Considers credit standing of lessee.
 Length of the lease.
 Status of the residual value (guaranteed versus
unguaranteed).

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 Lessor Accounting

Economics of Leasing
In Examples 1 and 2, CNH determined the implicit rate to be 4 percent,
the fair value of the equipment to be €100,000, and the residual value to
be $5,000. CNH then computes the lease payment as shown.

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 Classification of leases by Lessor

For accounting purposes, the lessor classifies leases as a

 Finance lease, or
 Operating lease.

For a finance lease, it must be non-cancelable and meet at least

one of five tests in Illustration 21.18 (next slide).

To meet one of these five tests, the lessor must transfer control of
a substantial portion of the underlying asset to the lessee or
provide ownership of the underlying asset to the lessee.

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21-38
 Classification of leases by Lessor

Transfer of Ownership Test

 If the lease transfers ownership of the asset to the lessee, it is
a finance lease.

Purchase Option Test

 The lease purchase option allows the lessee to purchase
the property for a price that is significantly lower than the
underlying asset’s expected fair value at the date the option
becomes exercisable (bargain purchase option).

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 Classification of leases by Lessor
Lease Term Test

 When the lease term is a major part of the remaining economic life of
the leased asset, companies should use the finance method.

 Guideline: If the lease term is 75 percent or greater of the economic

life of the leased asset, the lease meets the lease term test.

Present Value Test

 If the present value of the lease payments is reasonably close

to the fair value of the asset, the lessee should use the finance
method.

 Guideline: if the present value of the lease payments equals or

exceeds 90 percent of the fair value of the asset, then a lessee
should use the finance method.

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 Classification of leases by Lessor
Lease Payments

1. Fixed payments.

2. Variable payments.

3. Residual values (guaranteed or not).

4. Payments the lessee is reasonably certain to exercise.

Discount Rate
 Implicit rate should be used to determine the present value of the
payments.
 Defined as the discount rate that, at commencement of the lease,
causes the present value of the lease payments and unguaranteed
residual value to be equal to the fair value of the leased asset.

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 Classification of leases by Lessor

Alternative use
If at the end of the lease term the lessor does not have an
alternative use for the asset, the lessee classifies the lease as a
finance lease.
The assumption is that the lessee uses all the benefits from the
leased asset and therefore the lessee has essentially purchased the
asset.

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 Lessor Accounting-General Principles

For a sales-type lease,

 the lessor accounts for the lease in a manner similar to the sale
of an asset.
 the lessor generally records a Lease Receivable and eliminates
the leased asset.
 the lease receivable is computed as shown.

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 Lessor Accounting: Sales-type Lease
Illustration: CNH Financial Services Corp. and Ivanhoe Construction sign a lease
agreement dated January 1, 2022, that calls for CNH to lease a backhoe to
Ivanhoe beginning January 1, 2022. The terms and provisions of the lease
agreement, and other pertinent data, are as follows.
• The term of the lease is five years. The lease agreement is non-cancelable,
requiring equal rental payments at the beginning of each year (annuity-due
basis).
• The backhoe has a fair value at the commencement of the lease of €100,000,
an estimated economic life of five years, and a guaranteed residual value of
€5,000 (which is less than the expected residual value of the backhoe at the
end of the lease). Further, assume the underlying asset (the backhoe) has an
€85,000 cost to the dealer, CNH.
• The lease contains no renewal options. The backhoe reverts to CNH at the
termination of the lease.
• Collectibility of payments by CNH is probable.

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 Lessor Accounting: Sales-type Lease

• CNH sets the annual rental payment to earn a rate of return of 4 percent per
year (implicit rate) on its investment.

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 Lessor Accounting: Sales-type Lease

The lease meets the criteria for classification as a finance (sales-

type) lease because

1. Lease term is equal to the economic life of the asset.

2. Present value of the lease payments is €100,000, which is

100% (greater than or equal to 90%) of the fair value of the
backhoe.

That is, Ivanhoe will consume substantially the entire underlying

asset over the lease term.

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 Lessor Accounting: Sales-type Lease

CNH computes the lease receivable as shown.

The journal entries on January 1, 2022, are as follows.

Lease Receivable 100,000

Sales Revenue 100,000
Cost of Goods Sold 85,000
Inventory 85,000
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 Lessor Accounting: Sales-type Lease

On January 1, 2022, CNH records receipt of the first year’s lease payment
Cash 20,711.11
Lease Receivable 20,711.11
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 Lessor Accounting: Sales-type Lease

On December 31, 2022, CNH recognizes the interest revenue on the lease
receivable during the first year through the following entry.

Lease Receivable 3,171.56

Interest Revenue 3,171.56
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 Lessor Accounting: Sales-type Lease

The balance sheet as it relates to lease transactions at December 31, 2022.

On its December 31, 2022, income statement, CNH reports,

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 Lessor Accounting: Sales-type Lease

The following entries record receipt of the second year’s lease payment and
recognition of the interest revenue in 2023.

Jan. 1 Cash 20,711.11

Lease Receivable 20,711.11
IvanhoeLease
Dec. 31
records accrued interest
Receivable 2,469.97on December 31, 2019
Interest Revenue 2,469.97

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 Lessor Accounting: Sales-type Lease

CNH makes the following entry on December 31, 2026.

Ivanhoe records accrued interest on December 31, 2019
Lease Receivable 192.19
Lease Revenue 192.19
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 Lessor Accounting: Sales-type Lease

At January 1, 2027, when the leased asset is returned to CNH.

Inventory 5,000
Lease Receivable 5,000
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 Lessor Accounting: Sales-type Lease

Guaranteed Residual Value: In the Ivanhoe/CNH example, Ivanhoe

guaranteed a residual value of €5,000. In computing the amount to be
recovered from the rental payments, the present value of the residual value
was subtracted from the fair value of the backhoe to arrive at the amount to be
recovered by the lessor. Illustration 21.26 shows this computation.

Computation is same whether residual value is guaranteed or unguaranteed.

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 Lessor Accounting: Sales-type Lease

Unguaranteed Residual Value

In this case, there is less certainty that the unguaranteed residual portion of
the asset has been “sold.”
 The lessor recognizes sales revenue and cost of goods sold only for
the portion of the asset for which recovery is assured.
 Both sales revenue and cost of goods sold are reduced by the present
value of the unguaranteed residual value.
 The gross profit computed will still be the same amount as when a
guaranteed residual value exists.

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 Lessor Accounting: Sales-type Lease

To compare a sales-type lease with a guaranteed residual value to one with

an unguaranteed residual value, assume the same facts as in the
CNH/Ivanhoe lease situation. That is:

1. The sales price is €100,000.

2. The expected residual value is €5,000 (the present value of which is

€4,109.65).

3. The leased equipment has an €85,000 cost to the dealer, CNH.

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 Lessor Accounting: Sales-type Lease

Computation of Lease Amounts by CNH Financial—Sales-Type

Lease

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 Lessor Accounting: Sales-type Lease

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 Lessor Accounting: Operating Lease
The following data relates to a lease agreement between Hathaway Disposal
Ltd. and M&S for the use of one of Hathaway’s standard cardboard
compactors. Information relevant to the lease is as follows.
• The term of the lease is three years. The lease agreement is non-
cancelable, requiring three annual rental payments of £17,620.08, with the
first payment on January 1, 2022 (annuity-due basis).
• The compactor has a cost and fair value at commencement of the lease of
£60,000, an estimated economic life of five years, and a residual value at
the end of the lease of £12,000 (unguaranteed).
• The lease contains no renewal options. The compactor reverts to
Hathaway at the termination of the lease.
• The implicit rate of the lessor is known by M&S. Traylor’s incremental
borrowing rate is 6 percent. Hathaway sets the annual rental rate to earn a
rate of return of 6 percent per year (implicit rate) on its investment.
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 Lessor Accounting: Operating Lease

Hathaway classifies the lease as an operating lease because none of the

finance lease tests are met.

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 Lessor Accounting: Operating Lease

Under the operating method, Hathawary (the lessor)

 continues to recognize the asset on its statement of financial
position and recognizes lease revenue (generally on a
straight-line basis) in each period.
 continues to depreciate the leased asset.

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 Lessor Accounting: Operating Lease

To illustrate the operating method for the Hathaway/M&S lease, Hathaway

records the lease payment on a straight-line basis on January 1, 2022, 2023,
and 2024, as follows.

Cash 17,620.08
Unearned Lease Revenue 17,620.08

On December 31, 2022, 2023, and 2024, Hathaway records the recognition of
the revenue each period as follows.

Unearned Lease Revenue 17,620.08

Lease Revenue 17,620.08

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 Lessor Accounting: Operating Lease

Hathaway also records depreciation expense on the leased equipment

(assuming double-declining-balance, given a cost basis of £60,000, and a
five-year economic life), as follows.

Depreciation Expense (£60,000 × 40%) 24,000.00

Accumulated Depreciation—Equipment 24,000.00

Hathaway records other costs related to the lease arrangement, such as

insurance, maintenance, and taxes in the period incurred.

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