The four criteria for a capital lease are title transfer, bargain purchase option, lease term at least

75% of the estimated economic life of the asset, and present value of minimum lease payments at
least 90% of the fair market value of the asset (Roger Mnemonic: TT/BPO/75/90). If any one of these
criteria is met, the lessee classifies the lease as a capital lease.
Under IFRS, when a lease involves land and building, it is separated into two leases and the land
portion is accounted for separately from the building portion. Since the building lease is for 100% of
the buildings 20 year useful life, it clearly transfers substantially all of the rights and risks of
ownership and will be accounted for as a finance lease.
When a seller-lessee has transferred substantially all the risks of ownership to the buyer-lessor, the
leaseback will be considered a minor leaseback. The seller-lessee will report the sale as a separate
transaction, recognizing any gain or loss.
When a seller-lessee retains the right to substantially all of the remaining use of the property, the
sale and the leaseback are viewed as related transactions. Any gain on the sale is deferred and
amortized over the term of the lease. The amortization reduces rent expense if the leaseback is
accounted for as an operating lease, or reduces amortization of the leased asset if accounted for as
a capital lease.
The lease obligation will initially be determined using the rate implicit in the lease since it is known to
the lessee and lower than the lessees incremental borrowing rate. The first payment is made at
the inception of the lease and does not include interest. The second payment will be applied to
interest first with the remaining applied to the lease obligation.
With a lease term equal to 5 years of the assets 6 year useful life, the lease is a capital lease and
will result in the recognition of an asset and a liability equal to the present value of the minimum
lease payments. Five annual $100,000 payments made at the beginning of each year is an annuity
due with a present value of $100,000 x 4.4651 or $446,510. The guaranteed residual value is a
single payment due at the end of the lease, five years from its inception, resulting in a present value
of $20,000 x 0.7473 or $14,946. The total amount to be recorded will be $446,510 + $14,946, or
$461,456.
Since the lease is a direct financing lease, the lessor will not recognize any gain or loss on the sale
of the leased asset and will only recognize interest income over the term of the lease, using the rate
implicit in the lease. The lessee will record the asset at its present value using the lessees
incremental borrowing rate, resulting in a cost of $29,440 ($4,000 x 7.360). Over a 10 year useful life
(and lease term), straight-line depreciation will be $2,944 per year.
Because this is a capital lease with no title transfer and no bargain purchase option, for financial
reporting the lessee must depreciate the asset over the shorter of either the economic useful life or
lease term. If TT or BPO, use useful life. The amount will be equal to the present value of the
minimum lease payments, excluding executory costs, provided it does not exceed the fair market
value of the leased asset.
A guaranteed residual value is considered one component of the minimum lease payments. As a
result, it is included in calculating the capitalized amount of the asset and obligation under the lease.

The amount will be the present value of the payment to be made in a lump sum at the end of the
lease term.
Payments made on a capital lease are first applied to interest with the remainder reducing the lease
obligation. As the lease obligation declines each year, the amount recognized as interest expense
also decreases. When lease payments are equal, as the interest portion declines, the principal
reduction increases. As a result, the principal reduction in the fifth year would be greater than the
fourth year and smaller than the reduction in the sixth year.
The new walls and offices costing $360,000 will be capitalized as leasehold improvements and
amortized over the 5-year term of the lease. Amortization will be $72,000 per year or $6,000 per
month.
A lessee records a capital lease at the lower of either fair market value of the leased property or the
present value of the minimum lease payments. The present value of the minimum lease payments is
calculated by multiplying the periodic payment amount by a present value factor of an annuity or
annuity due, and then adding the present value of any bargain purchase option (BPO) or guaranteed
residual value (salvage value * PV of $1 factor)
Operating lease expense must be recognized evenly over the lease term. Dividing the total lease
payments by the total number of payment periods gives the uniform yearly lease expense.
When a lease involves land and building, if either title transfers at the end of the lease term or the
lease contains a bargain purchase option, the lessee will account for the land and building
separately. When it contains neither of those provisions, the land will be evaluated to determine if it
is significant, representing at least 25% of the combined value of land and building. If not, the lease
will be treated as a single building lease. If so, the land and building are accounted for separately. A
lease involving land only that transfers title to the lessee at the end of the lease term will only be
accounted for as a sales-type or direct-financing lease by the lessor if the criteria applying to the
lessor regarding the collectability of lease payments and certainty of costs are also met. Otherwise,
the lease is accounted for as an operating lease. In a lease involving land and building that contains
a bargain purchase option, a lessor with a manufacturers or dealers profit or loss will account for
the leases of the land and building as a single sales-type lease.
If lessor wishes to earn 8% on a 5 year lease, the present value of the payments at 8% will equal the
fair value of the equipment. Factor at 8% x payment = fair value of equipment
Under IFRS, a lease can only be an operating lease or a finance lease. It is a finance lease if it
transfers substantially all of the rights and risks of ownership as indicated by both the fact that the
lease term is for substantially all of the assets useful life (10 years of 12 years) and the lease
contains what appears to be a bargain purchase option.
A sale-leaseback occurs when the property owner sells property and immediately leases all or part
of it back from the new owner. When the present value of the payments under the leaseback is equal
to at least 90% of the fair value of the property at inception, the leaseback is accounted for as a
capital lease. The sale and the leaseback are considered related transactions and, as a result, no

gain is recognized on the sale. It is instead all deferred and recognized over the life of the leaseback
as a reduction of depreciation expense.
When a capital lease is recorded, the initial balance of the liability will be equal to the present value
of the minimum lease payments, which includes a bargain purchase option. If properly recorded,
when the lease expires, the unamortized amount of the liability will be equal to the bargain purchase
option. Since Cotts amortization table resulted in a zero balance, the amount initially recorded as a
liability must have excluded the bargain purchase option. If any of the other errors had been made,
the balance in the liability account at the end of the lease term would have been less than zero.
In an operating lease, the lessor recognizes rental revenue and the lessee recognizes rental
expense uniformly over the term of the lease regardless of the pattern of payments. When payments
increase or decrease during the term of the lease, when the lease contains periods that may be rent
free, or involves nonrefundable deposits, the total of the payments are spread equally over the term
of the lease. In this lease, Graf will report rental revenue each year equal to 1/5 of the total to be
received over the term of the lease.
In a sale-leaseback transaction, the gain will not be recognized on the income statement but would
be reported as a deferred credit in the liability section of the balance sheet. It will then be amortized
over the term of the lease with the amortization reported as a reduction of rent expense.