ACCOUNTING FOR LEASES

A lease is a contract conveying the right to use property, usually for a period of time. The owner
of the property for which the right is transferred is known as the lessor, and the party to whom
the right is transferred is known as the lessee. A further transfer of the right to use an asset from
a lessee is known as a sublease.
Terminology for leases

1. Bargain purchase option: a provision giving the lessee a right to buy the leased property
at a price so favourable that exercise of the option appears virtually assured at the
inception of the lease.
2. Bargain renewal option: a provision giving the lessee a right to renew a lease at a rental
so favourable that exercise of the option appears assured at the inception of the lease.
3. Contingent rentals: increases or decreases in lease payments after the inception of a lease
and resulting from changes in factors on which lease payments are based.
4. Estimated economic life of leased property: The estimated remaining period during
which the leased property is expected to be usable for the purpose for which it was
designed, with normal repairs and maintenance, without being limited by the lease
term.
5. Estimated residual value of leased property: The estimated fair value of the leased
property at the end of the lease term.
6. Fair value of leased property: In a sales type lease, the fair value is the normal selling
price of the leased property adjusted for any unusual market conditions. In a direct
financing type lease, the cost or carrying amount of the property and the fair value should
be the same at the inception of a lease, unless substantial time has passed since the lessor
acquired the property.
7. Inception of lease: Date of the lease contract or commitment, if earlier.
8. Incremental borrowing rate: The rate that, at the inception of the lease, the lessee would
have incurred to borrow the funds necessary to purchase a leased asset.
9. Initial direct costs: Those costs (such as commissions, legal fees and costs of
processing documents) incurred by a lessor that are directly associated with negotiating
and completing a lease contract.
10. Interest rate implicit in the lease (lesso causes the aggregate present value to be equal to the fair value of
leased property to the
lessor.
11. Lease term: The fixed noncancellable term of a lease
12. Minimum lease payments: the payments that the lessee is obligated to make or can
be required to make.
13. Renewal or extension of lease: the continuation of a lease contract beyond the
original lease term, including a new lease for the same property with the same lessee.

Page 1 of 4
 ADVANTAGES OF LEASING
1. 100% financing at fixed rates. Leasing is often done with no money draw down,
which helps to conserve scarce cash for new or developing companies. Also lease
payments often remain fixed, which protects the lessee against inflation and increases in the cost of money.
Banks usually finance up to 80% with a variable rate.
2. Protection against obsolescence. Leasing permits rapid changes in equipment, reduces risk of obsolescence,
and in many cases passes the risk in residual value to the lessor.
3. Flexibility. Leasing is often more flexible because lease agreements may contain less restrictive provisions
than other debt agreements.
4. Less costly financing. Some companies find leasing cheaper than other forms of financing. Tax benefits can
be passed to lessees in the form of lower rental payments.
5. Off balance sheet financing. Leasing in a certain manner does not add debt on a balance sheet, and
does not affect ratios and hence may add borrowing capacity.
6. Temporary requirement of the asset. Leasing may enable the lessee to avoid owning assets that are needed
only temporarily, seasonally or sporadically.
7. Increased liquidity. The use of sale-leaseback arrangements may permit the firm to increase its liquidity
by converting an existing asset into cash, which can be used as working capital. A firm short of working
capital or in liquidity squeeze can sell an owned asset to a lessor and lease the asset back for a specified
number of years.

DISADVANTAGES OF LEASING
1. Lower quality product. Leasing ready to use (as opposed to custom made) equipment may result in
lower quality products and ultimately loss of sales to the lessee.
2. Obsolescence considerations. If a lessee leases (under a finance lease) an asset that subsequently
becomes obsolete, it still have to make lease payments over the remaining period of the lease. Because
of that a lessee may use obsolete equipment leading to higher costs and uncompetitive products.
3. High interest cost. In some cases the 100% financing of assets may lead to higher interest costs.
4. Uncertainty over availability of the asset. Seasonal leasing entails uncertainty that the equipment will be
available when needed.
5. Lack of salvage value. At the end of the lease term the salvage value is realized by the lessor.

ACCOUNTING BY LESSEES
Leases are classified for accounting purposes by lessees as either capital/finance leases or operating
leases.
A lease is a capital or a finance lease if it meets any one of the following criteria.
1. The lease transfers ownership of the leased property to the lessee by the end of the lease term.
2. The lease contains a bargain purchase option.
Page 2 of 4
 3. The lease term is equal to 75% or more of the estimated economic life of the leased property.
4. The present value of the minimum lease payments is at least 90% or more of
the fair value of the leased property.

Any lease that does not qualify as a capital or finance lease is an

operating lease.
Any lease payments are treated as expenses.

Lease rental expense xx

Cash xx

A lessee records a capital or a finance lease as both an asset and liability equal
to the present value of the minimum lease payments. In discounting the lessee
uses the lessee’s incremental borrowing

However there is one exception to this rule. If (1) the lessee knows the
implicit rate computed by the lessor and (2) the implicit rate computed by the
lessor is lower than the lessee’s incr must use the implicit rate.

In discounting the minimum lease payments executory costs are excluded.

These costs like insurance, maintenance and taxes paid during the term of the
lease.

Illustration

On January 1,2015 Tencum ltd signed a 6-year lease for machinery. The terms of the lease
called for Tencum to make annual payments of sh. 500,000 for 6 years beginning January
1,2015. The machinery has an estimated economic life of 9 years. At the end of the lease term
Tencum has the right to buy the machinery for sh. 5,000. Tencum could have borrowed money
from the bank to buy the machinery at 10% p.a. The lessor computed the annual rentals using
an interest rate of 8% p.a.

Required:
i) Prepare a lease amortization schedule.
ii) Show the journal entries to record the lease and the payment of the annual
lease rentals.

Page 3 of 4
Illustration 11

ABC ltd entered into a lease agreement with XYZ ltd for an equipment beginning January 1,
2015. The lease agreement contains the following terms and provisions:

1. The term of the lease is 5 years, and the lease agreement is noncancellable, requiring
equal rental payments of sh. 2,598,162 at the beginning of each year.
2. The equipment has a fair value at the inception of the lease of sh. 10,000,000, an
estimated economic life of 5 years, and no residual value.
3. XYZ ltd pays all the executory costs except for the property taxes of sh. 200,000 per
year, which are included in the annual payments.
4. The lease contains no renewal options and the equipment reverts to ABC ltd at the
termination of the lease.
5. XYZ ltd incremental borrowing rate is 11% per year.
6. ABC ltd set the annual rental rate to ensure a rate of return on its investment of 10% per
year; this fact is known to XYZ ltd.
REQUIRED
a) Show accounting entry on 1/1/2015
b) Lease amortization schedule
c) The corresponding journal entries

Page 4 of 4