Prepared by

Coby Harmon
University of California, Santa Barbara
Westmont College
21-1
 CHAPTER 21
Accounting for Leases
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Describe the environment 3. Explain the accounting for
related to leasing transactions. leases by lessors.
2. Explain the accounting for 4. Discuss the accounting and
leases by lessees. reporting for special features
of lease arrangements.

21-2
 PREVIEW OF CHAPTER 21

Intermediate Accounting
IFRS 3rd Edition
Kieso ● Weygandt ● Warfield
21-3
 The Leasing Environment

A Look at the Lessor

Captive
Banks Independents Leasing
Companies
► Credit Suisse ► CNH Capital
(CHE) (NLD) (for CNH
► Chase (USA) Global),

► Barclays (GBR) ► BMW Financial

Services (DEU)
► Deutsche Bank (for BMW)
(DEU)
14% ► IBM Global
Financing (USA)
(for IBM)

55% Market Share 31%

21-4 LO 1
 The Leasing Environment

Advantages of Leasing—Lessor
1. Often provides profitable interest margins.

2. It can stimulate sales of a lessor’s product.

3. It often provides tax benefits to various parties in the

lease.

4. It can provide a high residual value to the lessor.

21-5 LO 1
 LEARNING OBJECTIVE 3
Lessor Accounting Explain the accounting for
leases by lessors.

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).

21-6 LO 3
 Accounting by the Lessor

Benefits to the Lessor

1. Interest revenue.

2. Tax incentives.

3. High residual value.

21-7 LO 4 Identify the classifications of leases for the lessor.

 Accounting by the Lessor

Economics of Leasing
A lessor determines the amount of the rental, based on the rate
of return—the implicit rate—needed to justify leasing the asset.
If a residual value is involved (whether guaranteed or not), the
company would not have to recover as much from the lease
payments

21-8 LO 4 Identify the classifications of leases for the lessor.

 Accounting by the Lessor
(Computation of Rental): Fieval Leasing Company signs an agreement
on January 1, 2010, 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, 2010, 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. Reid Company assumes direct responsibility for all executory costs.
5. The agreement requires equal annual rental payments, beginning on
January 1, 2010.

21-9 LO 4 Identify the classifications of leases for the lessor.

 Accounting by the Lessor
(Computation of Rental): 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) x 0.56447
PV of residual value £ 34,473

Fair market value of leased equipment £ 343,000

Present value of residual value - (34,473)
Amount to be recovered through lease payment 308,527
PV factor of annunity due (i=10%, n=6) ÷ 4.79079
Annual payment required £ 64,400

21-10 LO 4 Identify the classifications of leases for the lessor.

 Classification of Leases by the Lessor

For accounting purposes, the lessor classifies leases as a

◆ Finance lease or an,
◆ Operating lease.
For a finance lease, it must be non-cancelable and meet at least
one of five tests in Illustration 21.18.

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.

21-11 LO 3
 For a finance lease,
• must be non-
cancelable and
• meet at least one
of the five tests.

ILLUSTRATION 21.218
Lease Classification Tests
21-12 LO 3
 Classification of Leases by the 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).

21-13 LO 3
 Classification of Leases by the 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.

21-14 LO 3
 Classification of Leases by the Lessor

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.

21-15 LO 3
 Classification of Leases by the Lessor

Lease Payments
Generally include:

1. Fixed payments.

2. Variable payments.

3. Residual values (guaranteed or not).

4. Payments the lessee is reasonably certain to exercise.

21-16 LO 3
 Classification of Leases by the Lessor

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.

21-17 LO 3
 Alternative Use Test

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.

21-18 LO 3
 Accounting by the Lessor

Classification of Leases by the Lessor

1. Operating leases.

2. Finance Lease:

a. Direct-financing leases.

b. Sales-type leases.

21-19 LO 4 Identify the classifications of leases for the lessor.

 Accounting by the Lessor

Classification of Leases by the Lessor

Illustration 21-10

21-20 LO
 Accounting by the Lessor

Direct-Financing Method (Lessor)

In substance the financing of an asset purchase by the lessee.
Lessor records:
◆ A lease receivable instead of a leased asset.
◆ Receivable is the present value of the minimum lease
payments plus the present value of the unguaranteed
residual value.

21-21 LO 5 Describe the lessor’s accounting for direct-financing leases.

 Accounting by the Lessor
Fieval Leasing Company signs an agreement on January 1, 2010, 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, 2010, 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. Reid Company assumes direct responsibility for all executory costs.
5. The agreement requires equal annual rental payments, beginning on
January 1, 2010.
6. Assuming the lessor desires a 10% rate of return on its investment, Annual
rental payment is £ 64.400
21-22 LO 4 Identify the classifications of leases for the lessor.
 Accounting by the Lessor

Amortization schedule that would be suitable for the lessor.

21-23 LO 5 Describe the lessor’s accounting for direct-financing leases.

 Accounting by the Lessor

Prepare all of the journal entries for the lessor for 2010 and 2011.

1/1/10 Lease Receivable 343,000

Equipment 343,000

1/1/10 Cash 64,400

Lease Receivable 64,400

12/31/10 Interest Receivable 27,860

Interest Revenue 27,860

21-24 LO 5 Describe the lessor’s accounting for direct-financing leases.

 Accounting by the Lessor

Prepare all of the journal entries for the lessor for 2010 and 2011.

1/1/11 Cash 64,400

Lease Receivable 36,540

Interest Receivable 27,860

12/31/11 Interest Receivable 24,206

Interest Revenue 24,206

21-25 LO 5 Describe the lessor’s accounting for direct-financing leases.

 Accounting by the Lessor

Operating Method (Lessor)

◆ Records each rental receipt as rental revenue.

◆ Depreciates leased asset in the normal manner.

21-26 LO 5 Describe the lessor’s accounting for direct-financing leases.

 Accounting by the Lessor

Illustration: Assume Fieval accounts for the lease as an

operating lease. It records the cash rental receipt as follows:

Cash 64,400
Rental Revenue 64,400

Depreciation is recorded as follows:

Depreciation Expense 46,989

Accumulated Depreciation 46,989
($343,000 – 61,067) / 6 years = 57,167

21-27 LO 5 Describe the lessor’s accounting for direct-financing leases.

 Comprehensive Example

Lessor Accounting for Operating Leases

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, 2019 (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
21-28 rate of return of 6 percent per year (implicit rate) on its investment. LO 3
 Lessor Accounting for Operating Leases

Hathaway classifies the lease as an operating lease because none of

the finance lease tests are met.

ILLUSTRATION 21.30
Lease Classification Tests
21-29 LO 3
 Lessor Accounting for Operating Leases

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.

21-30 LO 3
 Lessor Accounting for Operating Leases

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

Hathaway records the lease payment on a straight-line basis on
January 1, 2019, 2020, and 2021, as follows.

Cash 17,620.08
Unearned Lease Revenue 17,620.08

On December 31, 2019, 2020, and 2021, Hathaway records the

recognition of the revenue each period as follows.

Unearned Lease Revenue 17,620.08

Lease Revenue 17,620.08

21-31 LO 3
 Lessor Accounting for Operating Leases

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.

21-32 LO 3
 Special Accounting Problems

1. Residual values Lessee & Lessor.

2. Sales-type leases (lessor).

3. Bargain-purchase options.

4. Initial direct costs.

5. Current versus non-current classification.

6. Other lease adjustments.

7. Presentation, disclosure, and analysis.

LO 6 Identify special features of lease arrangements

21-33
that cause unique accounting problems.
 Special Accounting Problems

Residual Values
Meaning of Residual Value - Estimated fair value of the
leased asset at the end of the lease term.

Guaranteed Residual Value – Lessee agrees to make up

any deficiency below a stated amount that the lessor
realizes in residual value at the end of the lease term.

LO 6 Identify special features of lease arrangements

21-34
that cause unique accounting problems.
 Special Accounting Problems

Residual Values
Lease Payments - Lessor may adjust lease payments
because of the increased certainty of recovery of a
guaranteed residual value.

Lessee Accounting for Residual Value - The minimum

lease payments, include the guaranteed residual value but
excludes the unguaranteed residual value.

LO 6 Identify special features of lease arrangements

21-35
that cause unique accounting problems.
 Special Accounting Problems
Illustration (Guaranteed Residual Value): CNH Capital (NLD) (a
subsidiary of CNH Global) and Ivanhoe Mines Ltd. (CAN) sign a lease
agreement dated January 1, 2012, that calls for CNH to lease a front-end
loader to Ivanhoe beginning January 1, 2012. 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
noncancelable, requiring equal rental payments at the beginning of
each year (annuity-due basis).
◆ The loader has a fair value at the inception of the lease of $100,000,
an estimated economic life of five years, and estimated residual
value of $5,000 at the end of the lease..

LO 7 Describe the effect of residual values, guaranteed and

21-36
unguaranteed, on lease accounting.
 Special Accounting Problems

Lessor Accounting for Residual Value

The lessor works on the assumption that it will realize the residual value at
the end of the lease term whether guaranteed or unguaranteed.

Illustration: Assume a direct-financing lease with a residual value (either

guaranteed or unguaranteed) of $5,000. CNH determines the payments
as follows.
Illustration 21-23

LO 7 Describe the effect of residual values, guaranteed and

21-37
unguaranteed, on lease accounting.
 Special Accounting Problems

Lessor Accounting for Residual Value

Illustration: Lease Amortization Schedule, for Lessor.
Illustration 21-24

21-38
LO 7
 Special Accounting Problems

Lessor Accounting for Residual Value

Illustration: CNH would make the following entries for this direct-financing
lease in the first year.
Illustration 21-25

LO 7 Describe the effect of residual values, guaranteed and

21-39
unguaranteed, on lease accounting.
 Lessor—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.
ILLUSTRATION 21.26

Computation is same whether residual value is guaranteed or

unguaranteed.
21-40 LO 3
 Lessor—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.

21-41 LO 3
 Special Accounting Problems

Sales-Type Leases (Lessor)

◆ Primary difference between a direct-financing lease and
a sales-type lease is the manufacturer’s or dealer’s gross
profit (or loss).

◆ Lessor records the sale price of the asset, the cost of

goods sold and related inventory reduction, and the
lease receivable.

◆ Difference in accounting for guaranteed and

unguaranteed residual values.

21-42 LO 8 Describe the lessor’s accounting for sales-type leases.

 Classification of Leases by the Lessor

Accounting Measurement and Presentation

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.

21-43 ILLUSTRATION 21.19 LO 3

 Special Accounting Problems

Sales-Type Leases (Lessor)

Illustration: To illustrate a sales-type lease with a guaranteed
residual value and with an unguaranteed residual value, assume
the same facts as in the preceding direct-financing lease
situation. The estimated residual value is $5,000 (the present
value of which is $3,104.60), and the leased equipment has an
$85,000 cost to the dealer, CNH. Assume that the fair market
value of the residual value is $3,000 at the end of the lease term.

21-44 LO 8 Describe the lessor’s accounting for sales-type leases.

 Special Accounting Problems

Sales-Type Leases (Lessor)

Illustration: Computation of Lease Amounts by CNH Financial—
Sales-Type Lease
Illustration 21-27

21-45 LO 8 Describe the lessor’s accounting for sales-type leases.

 Special Accounting Problems

Sales-Type Leases (Lessor)

Illustration: CNH makes the following entries.
Illustration 21-28

21-46 LO 8 Describe the lessor’s accounting for sales-type leases.

 Special Accounting Problems

Sales-Type Leases (Lessor)

Illustration: CNH makes the following entries.
Illustration 21-28

21-47 LO 8 Describe the lessor’s accounting for sales-type leases.

 Special Lease Accounting Problems

Other Lease Adjustments

Initial direct costs are incremental costs of a lease that would
not have been incurred had the lease not been executed.
Examples of costs included and excluded from initial direct costs from
the lessee and lessor side. ILLUSTRATION 21.33
Initial Direct Costs

21-48 LO 4
 Special Accounting Problems

Initial Direct Costs (Lessor)

Accounting for initial direct costs:

◆ Operating leases, the lessor should defer initial direct

costs and amortizes them as expenses over the term of
the lease.

◆ Sales-type leases, the lessor expenses the initial direct

costs.

◆ Direct-financing lease, the lessor adds initial direct

costs to the net investment.

21-49 LO 8 Describe the lessor’s accounting for sales-type leases.

 APPENDIX 21A Sale-Leasebacks

Sale-Leaseback Example
Japan Airlines (JAL) (JPN) on January 1, 2019, sells a used Boeing 757 having a
carrying amount on its books of $30,000,000 to CitiCapital for $33,000,000. JAL
immediately leases the aircraft back under the following conditions:
• The term of the lease is seven years. The lease agreement is non-
cancelable, requiring equal rental payments of $4,881,448 at the end of
each year (ordinary annuity basis), beginning December 31, 2019.
• The lease contains no renewal or purchase options. The plane reverts to
CitiCapital at the termination of the lease.
• The aircraft has a fair value of $33,000,000 on January 1, 2019, and an
estimated remaining economic life of 10 years. The residual value
(unguaranteed) at the end of the lease is $13,000,000.
• The annual payments assure the lessor an 8 percent return (which is the
same as JAL’s incremental borrowing rate).
21-50 LO 5
 Sale-Leaseback Example - Lessor
Applying the classification tests, the lease-back of the airplane is
classified as an operating lease because none of the sales-type
lease criteria are met, as indicated in Illustration 21A.3.

ILLUSTRATION 21A.3
Lease Classification Tests
21-51 LO 5
 Sale-Leaseback Example
This arrangement is accounted for as a sale because the
leaseback does not transfer control of the asset back to JAL; only
the right-of-use for seven years is granted through the lease.

Partial Lease Amortization Schedule

ILLUSTRATION 21A.4
Comparative Entries for Sale-Leaseback for Lessee and Lessor

21-52 LO 5
 Cash 33,000,000
Right-of-Use Asset 23,104,205
Aircraft 30,000,000
Gain on Sale 689,580
Lease Liability 25,414,625

Depreciation Expense 3,300,661

Right-of-Use Asset 3,300,661
(23,104,625:7 = 3,300,661)

Depreciation Expense 3,300,661

Right-of-Use Asset 3,300,661
(23,104,625:7 = 3,300,661)

ILLUSTRATION 21A.4
Comparative Entries for Sale-Leaseback for Lessee and Lessor

21-53 LO 5
 Special Lease Accounting Problems

Presentation, Disclosure, and Analysis

Presentation
Summary of how the lessee reports the information related to
finance and operating leases in the financial statements.

ILLUSTRATION 21.35
Presentation in Financial Statements—Lessee

21-54 LO 4
 Presentation, Disclosure, and Analysis

Presentation
Summary of how the lessor reports the information related to
sales-type and operating leases in the financial statements.

ILLUSTRATION 21.36
Presentation in Financial Statements—Lessor

21-55 LO 4
 Presentation, Disclosure, and Analysis

Disclosure
Lessees and lessors must also provide additional qualitative and
quantitative disclosures to help financial statement users assess
the amount, timing, and uncertainty of future cash flows. Qualitative
disclosures to be provided by both lessees and lessors are
summarized as shown.

ILLUSTRATION 21.37
Qualitative Lease Disclosures

21-56 LO 4
 Presentation, Disclosure, and Analysis

Disclosure
This illustration presents the type of quantitative information that
should be disclosed for the lessee.

ILLUSTRATION 21.38
Lessee Quantitative Disclosures

21-57 LO 4
 Presentation, Disclosure, and Analysis

Disclosure
This illustration presents the type of quantitative information that
should be disclosed for the lessor.

ILLUSTRATION 21.40
Lessor Quantitative Disclosures

21-58 LO 4
 Presentation, Disclosure, and Analysis

Analysis
With the increase in the assets and liabilities, a number of financial
metrics used to measure the profitability and solvency of
companies will change.
• Return on assets will decrease.

• Earnings before interest, taxes, and depreciation and

amortization (EBIDTA), which likely will require some
adjustments as companies depreciate right-of-use assets and
record interest expense.

• Debt to equity ratio will increase, and the interest coverage ratio
will decrease.

21-59 LO 4
 Pertanyaan Partisipasi #1

⚫ True or False.

⚫ In computing the annual lease payments, the lessor

deducts only a guaranteed residual value from the fair
value of a leased asset.

21-60
 Pertanyaan Partisipasi #2

⚫ True or False

⚫ Under an operating lease, the lessor records each lease

receipt as part interest revenue and part lease revenue.

21-61
 Pertanyaan Partisipasi #3

⚫ True or False

⚫ The basic difference between a direct-financing lease and

a sales-type lease relates to the recognition of the profit
on the sale.

21-62
 Pertanyaan Partisipasi #4

In a lease that is recorded as a sales-type lease by the lessor, interest

revenue
A. should be recognized in full as revenue at the lease’s inception
B. should be recognized over the period of the lease using the
straight-line method
C. should be recognized over the period of the lease using the
effective interest method
D. does not arise

21-63
 GLOBAL ACCOUNTING INSIGHTS

LEARNING OBJECTIVE 7
Compare the accounting for leases under IFRS and U.S. GAAP.

Relevant Facts
Following are the key similarities and differences between U.S. GAAP and
IFRS related to leases.
Similarities

◆ Both GAAP and IFRS share the same objective of recording leases by
lessees and lessors according to their economic substance—that is,
according to the definitions of assets and liabilities.
◆ Much of the terminology for lease accounting in IFRS and GAAP is the
same.

21-64 LO 7
 GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
Similarities

◆ Both GAAP and IFRS require lessees to recognize a right-of-use asset

and related lease liability for leases with terms longer than one year.
◆ Under both IFRS and GAAP, lessors use the same general criteria
(consistent with the recent standard on revenue) to determine if there is
transfer of control of the underlying asset and if lessors classify leases
as sales-type or operating.
◆ GAAP and IFRS use the same lessor accounting model for leases
classified as sales-type or operating.
◆ GAAP and IFRS have similar qualitative and quantitative disclosure
requirements for lessees and lessors.

21-65 LO 7
 GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
Differences

◆ U.S. GAAP continues to use a classification test for lessees under ASC
842. Thus, lessees account for some leases using the finance lease
method. Leases classified as operating leases under U.S. GAAP will be
accounted for differently compared to IFRS
◆ IFRS allows alternative measurement bases for the right-of-use asset
(e.g., the revaluation model, in accordance with IAS 16, Property, Plant
and Equipment).
◆ While both U.S. GAAP and IFRS have a short-term lease exception,
U.S. GAAP does not have the additional lessee recognition and
measurement exemption for leases of assets of low value (e.g., personal
computers, small office furniture).
21-66 LO 7
 GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
Differences

◆ IFRS 16 includes explicit guidance on collectibility of the lease payments

by lessors and amounts necessary to satisfy a residual value guarantee.
◆ U.S. GAAP distinguishes between sales-type and direct financing leases
for lessors (which defers gross profit on direct financing leases).
Therefore, IFRS 16 permits recognition of selling profit on direct
financing leases at lease commencement.

21-67 LO 7
 GLOBAL ACCOUNTING INSIGHTS

On the Horizon
Lease accounting is one of the areas identified in the IASB/FASB
Memorandum of Understanding. The Boards have developed rules based on
“right-of-use” (ROU) which require that all leases with terms longer than one
year be recorded on the statement of financial position (balance sheet). The
IASB has decided on a single approach for lessee accounting. Under the IASB
approach, a lessee accounts for all leases as finance leases, recognizing
depreciation of the ROU asset separately from interest on the lease liability.
The FASB reached a different conclusion on the expense recognition for
operating-type leases. Under the FASB model, the income effects will reflect a
straight-line expense pattern, reported as a single total lease expense. The
Boards are generally converged with respect to lessor accounting.

21-68 LO 7
 Copyright

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21-69