Chapter Six

Accounting for
Leases
A lease is a contractual agreement between a lessor and a lessee. This arrangement 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.
Advantages of Leasing
The growth in leasing indicates that it often has some genuine advantages over owning property,
such as:
1. 100% financing at fixed rates. Leases are often signed without requiring any money down
from the lessee. This helps the lessee conserve scarce cash an especially desirable feature for
new and developing companies. In addition, lease payments often remain fixed, which protects
the lessee against inflation and increases in the cost of money.
2. Protection against obsolescence. Leasing equipment reduces risk of obsolescence to the
lessee, and in many cases passes the risk of residual value to the lessor. For example, Merck (a
pharmaceutical maker) leases computers. Under the lease agreement, Merck may turn in an old
computer for a new model at any time, canceling the old lease and writing a new one. The lessor
adds the cost of the new lease to the balance due on the old lease, less the old computer’s trade-in
value. As one treasurer remarked, “Our instinct is to purchase.” But if a new computer is likely
to come along in a short time, “then leasing is just a heck of a lot more convenient than
purchasing.”
Naturally, the lessor also protects itself by requiring the lessee to pay higher rental payments or
provide additional payments if the lessee does not maintain the asset.
3. Flexibility. Lease agreements may contain less restrictive provisions than other debt
agreements. Innovative lessors can tailor a lease agreement to the lessee’s special needs. For
instance, the duration of the lease the lease term may be anything from a short period of time to
the entire expected economic life of the asset. The rental payments may be level from year to
year, or they may increase or decrease in amount. The payment amount may be predetermined or
may vary with sales, the prime interest rate, the Consumer Price Index, or some other factor. In
most cases the rent is set to enable the lessor to recover the cost of the asset plus a fair return
over the life of the lease.
4. Less costly financing. Some companies find leasing cheaper than other forms of financing.
For example, start-up companies in depressed industries or companies in low tax brackets may
lease to claim tax benefits that they might otherwise lose.
Depreciation deductions offer no benefit to companies that have little if any taxable income.
Through leasing, the leasing companies or financial institutions use these tax benefits. They can
then pass some of these tax benefits back to the user of the asset in the form of lower rental
payments.
5. Tax advantages. In some cases, companies can “have their cake and eat it too” with tax
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advantages that leases offer. That is, for financial reporting purposes, companies do not report an

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asset or a liability for the lease arrangement. For tax purposes, however, companies can
capitalize and depreciate the leased asset. As a result, a company takes deductions earlier rather
than later and also reduces its taxes. A common vehicle for this type of transaction is a “synthetic
lease” arrangement, such as that described in the opening story for Krispy Kreme.
6. Off–balance-sheet financing. Certain leases do not add debt on a balance sheet or affect
financial ratios. In fact, they may add to borrowing capacity. Such off–balance-sheet financing
is critical to some companies.
Conceptual Nature of a Lease
Capitalize a lease that transfers substantially all of the benefits and risks of property ownership,
provided the lease is noncancelable.
Leases that do not transfer substantially all the benefits and risks of ownership are operating
leases.
Operating lease
Rent expense xxx
Cash xxx
Although technically legal title may not pass, the benefits from the use of the property do.
Capital lease
Leased equipment xxx
Lease liability xxx

ACCOUNTING BY THE LESSEE

The lessee capitalizes a lease, it records an asset and a liability generally equal to the present
value of the rental payments. The lessor, having transferred substantially all the benefits and
risks of ownership, recognizes a sale by removing the asset from the balance sheet and replacing
it with a receivable.
Lessee Lessor
Leased Equipment XXX Lease Receivable XXX
Lease Liability XXX Equipment XXX

Having capitalized the asset, Lessee records depreciation on the leased asset. Both Lessor and
lessee treat the lease rental payments as consisting of interest and principal. If lessee does not
capitalize the lease, it does not record an asset, nor does lessor remove one from its books. When
lessee makes a lease payment, it records rental expense; lessor recognizes rental revenue.
In order to record a lease as a capital lease, the lease must be non-cancelable. Further, it must
meet one or more of the four criteria listed.
Capitalization Criteria (Lessee)
The lease transfers ownership of the property to the lessee.
The lease contains a bargain-purchase option: allows the lessee to purchase the leased
property for a price that is significantly lower than the property’s expected fair value at
the date the option becomes exercisable. At the inception of the lease, the difference
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 between the option price and the expected fair value must be large enough to make
exercise of the option reasonably assured.
The lease term is equal to 75 percent or more of the estimated economic life of the leased
property.
If the lease period equals or exceeds 75 percent of the asset’s economic life, the lessor transfers
most of the risks and rewards of ownership to the lessee. Capitalization is therefore appropriate.
However, determining the lease term and the economic life of the asset can be troublesome.
The lease term is generally considered to be the fixed, noncancelable term of the lease. However,
a bargain-renewal option, if provided in the lease agreement, can extend this period. A bargain-
renewal option allows the lessee to renew the lease for a rental that is lower than the expected
fair rental at the date the option becomes exercisable. At the inception 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 assured.

The present value of the minimum lease payments (excluding executory costs) equals or
exceeds 90 percent of the fair value of the leased property.
IFRS does not specify an exact percentage, such as 90%. Instead, it uses the term
“substantially all.” This difference illustrates the distinction between rules-based and
principles-based standards.
Lessee classifies and accounts for leases that do not meet any of the four criteria as operating
leases. The table below shows that a lease meeting any one of the four criteria results in the
lessee having a capital lease.

At the inception of the lease, the difference between the option price and the expected fair value
must be large enough to make exercise of the option reasonably assured.

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Asset and Liability Accounted for Differently
In a capital lease transaction, lessee uses the lease as a source of financing. Lessor finances the
transaction (provides the investment capital) through the leased asset. Lessee makes rent
payments, which actually are installment payments. Therefore, over the life of the Asset rented,
the rental payments to Lessor constitute a payment of principal plus interest.
Asset and Liability Recorded
Under the capital lease method, Lessee treats the lease transaction as if it purchases the Asset in
a financing transaction. That is, Lessee acquires the Asset and creates an obligation. Therefore, it
records a capital lease as an asset and a liability at the lower of (1) the present value of the
minimum lease payments (excluding executory costs) or (2) the fair value of the leased asset at
the inception of the lease. The rationale for this approach is that companies should not record a
leased asset for more than its fair value.
Depreciation Period
One troublesome aspect of accounting for the depreciation of the capitalized leased asset relates
to the period of depreciation. If the lease agreement transfers ownership of the asset to Lessee
(criterion 1) or contains a bargain-purchase option (criterion 2), Lessee depreciates the Asset
consistent with its normal depreciation policy for other Assets, using the economic life of the
asset.
On the other hand, if the lease does not transfer ownership or does not contain a bargain-
purchase option, then Lessee depreciates it over the term of the lease. In this case, the Asset
reverts to Lessor after a certain period of time.
Effective-Interest Method
Throughout the term of the lease, Lessee uses the effective-interest method to allocate each
lease payment between principal and interest. This method produces a periodic interest expense
equal to a constant percentage of the carrying value of the lease obligation.
When applying the effective-interest method to capital leases, Lessee must use the same discount
rate that determines the present value of the minimum lease payments.
Depreciation Concept
Although Lessee computes the amounts initially capitalized as an asset and recorded as an
obligation at the same present value, the depreciation of the Asset and the discharge of the
obligation are independent accounting processes during the term of the lease. It should
depreciate the leased asset by applying conventional depreciation methods: straight-line, sum-of-
the-years’-digits, declining-balance, Chapters of production, etc.
The FASB uses the term “amortization” more frequently than “depreciation” to recognize
intangible leased property rights. We prefer “depreciation” to describe the write-off of a tangible
asset’s expired services.
Example-1: On January 1, 2012, Adams Corporation signed a 5-year noncancelable lease for a
machine. The terms of the lease called for Adams to make annual payments of $9,968 at the
beginning of each year, starting January 1, 2012. The machine has an estimated useful life of 6
years and a $5,000 unguaranteed residual value. Adams uses the straight-line method of
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depreciation for all of its plant assets. Adams’s incremental borrowing rate is 10%, and the
lessor’s implicit rate is unknown.
Required
(a) What type of lease is this? Explain.
(b) Compute the present value of the minimum lease payments.
(c) Prepare all necessary journal entries for Adams for this lease through January 1, 2013.
Solution
Capitalization Criteria: capital lease, No. 3
1. Transfer of ownership No
2. Bargain purchase option No
3. Lease term = 75% of economic life of leased
property Lease term 5 yrs.
Economic life 6 yrs.
YES 83.3%
4. Present value of minimum lease payments => 90% of FMV of property FMV of leased
property is unknown
To Compute present value of the minimum lease payments.
Payment $ 9,968
Present value factor (i=10%,n=5) 4.16986
PV of minimum lease payments $41,565

Journal Entries:
Leased Machine (under capital leases) 41,565
Lease Liability 41,565
Lease Liability 9,968
Cash 9,968
Lease Amortization Schedule

10%
Lease Interest Reductio Lease
Date Paymen Expense n in Liability
t Liability
1/1/12 $ 41,565
1/1/12 $ 9,968 $ 9,968 31,597
12/31/12 9,968 3,160 6,808 24,789
12/31/13 9,968 2,479 7,489 17,300
12/31/14 9,968 1,730 8,238 9,062
12/31/15 9,968 906 9,062 0

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Journal entries for Adams through Jan. 1, 2013.
12/31/12 (adjusting entry)
Depreciation Expense 8,313
Accumulated Depreciation 8,313
($41,565 ÷ 5 = $8,313)
Interest Expense 3,160
Interest Payable 3,160
($41,565 – $9,968) X .10]
Journal entries for Adams through Jan. 1, 2012.
1/1/13
Lease Liability 6,808
Interest Payable 3,160
Cash 9,968

Operating Method
The lessee assigns rent to the periods benefiting from the use of the asset and ignores, in the
accounting, any commitments to make future payments.
Illustration: Assume Adams accounts for it as an operating lease. Adams records this payment
on January 1, 2012, as follows.
Rent Expense 9,968
Cash 9,968
Comparison of Capital Lease with Operating Lease

E21- Finance Operating

1 Lease Lease
Date Depreciation Interest Expens Diff.
Expense Expense Total e
2012 $ 8,313 $ $ 11,473 $ 9,968 $ 1,505

3,160
2013 8,313 2,479 10,792 9,968 824
2014 8,313 1,730 10,043 9,968 75
2015 8,313 906 9,219 9,968 (749)
2016 8,313 8,313 9,968 (1,655)
$ 41,565 $ $ 49,840 $ 49,840 0

8,275

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ACCOUNTING BY THE LESSOR
Three important benefits are available to the lessor:
1. Interest revenue. Leasing is a form of financing. Banks, captives, and independent leasing
companies find leasing attractive because it provides competitive interest margins.
2. Tax incentives. In many cases, companies that lease cannot use the tax benefit of the asset,
but leasing allows them to transfer such tax benefits to another party (the lessor) in return for a
lower rental rate on the leased asset.
3. High residual value. Another advantage to the lessor is the return of the property at the end of
the lease term. Residual values can produce very large profits.
Classification of Leases by the Lessor
For accounting purposes, the lessor may classify leases as one of the following:
1. Operating leases.
2. Direct-financing leases.
3. Sales-type leases.

A sales-type lease involves a manufacturer’s or dealer’s profit, and a direct-financing lease does
not.

A lessor may classify a lease as an operating lease but the lessee may classify the same lease as

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a capital lease.

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Example 2 Fieval Leasing Company signs an agreement on January 1, 2012, to lease equipment
to Reid Company. The following information relates to this agreement.
1. The term of the non-cancelable lease is 6 years with no renewal option. The equipment
has an estimated economic life of 6 years.

2. The cost and fair value of the asset at January 1, 2012, is $343,000.

3. The asset will revert to the lessor at the end of the lease term, at which time the asset is
expected to have a residual value of $61,071, none of which is guaranteed.

4. The agreement requires equal annual rental payments, beginning on January 1, 2012.

Collectability of the lease payments is reasonably predictable. There are no important

uncertainties surrounding the amount of costs yet to be incurred by the lessor.
Assuming the lessor desires a 10% rate of return on its investment, calculate the amount of the
annual rental payment required.

Residual value $ 61,071

PV of single sum (i=10%, n=6) 0.56447
PV of residual value $ 34,473

Fair market value of leased equipment $ 343,000

Direct-Financing
Present Method
value of (Lessor)
residual value (34,473)
In substance the financing of an asset purchase by the
Amount to be recovered through lease 308,527
lessee.
Lessor r payment PV factor of annunity due (i=10%, 4.79079
ecords:
n=6) Annual payment required $ 64,400
 A lease receivable instead of a leased asset.
 Receivable is the present value of the minimum lease payments.

 Amortization schedule for the lessor.

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: Prepare all of the journal entries for the lessor for
2012 and 2013. 1/1/12 Lease Receivable
343,000
Equipment 343,000
1/1/12 Cash 64,400
Lease Receivable 64,400
12/31/12 Interest Receivable 27,860
Interest Revenue 27,860
1/1/12 Cash 64,400
Lease Receivable 36,540
Interest Receivable 27,860
12/31/12 Interest Receivable 24,206
Interest Revenue 24,206

Operating Method (Lessor)

 Records each rental receipt as rental revenue.

 Depreciates leased asset in the normal manner.

Illustration: Assume Fieval accounts for the lease as an operating lease. It

records the cash rental receipt as follows:
Cash 64,400
Rental Revenue
Accumulated Depreciation 46,989
($343,000 – 61,067) / 6 years = 57,167

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