LEASE ACCOUNTING

LEASE
 A contract or part of a contract that conveys the right to use* the underlying asset for a period of time in exchange for a consideration

*An entity has the right to control the use of an identified asset if it has both the right to:
1. Obtain substantially ALL the economic benefits from the use of the identified asset
2. Direct the USE of the identified asset

Types of Leases: Operating vs Finance Lease

Operating Lease Finance Lease
 Does not transfer substantially all the risks and rewards to  Transfers substantially ALL the risks and rewards of ownership
ownership of an underlying asset  Lessor ≠ owner*
 Lessor = owner
*If there is a (1) transfer of ownership, or (2) option to purchase

Characteristics of a Finance Lease

It is considered as a finance lease if any of the following exists:
1. Transfer of ownership
2. Option to purchase the asset
3. Material lease term (LT ≥ 75% of useful life)
4. Substantial present value of lease payments (PV ≥ 90% of fair value)

OPERATING LEASE AND FINANCE LEASE IN LESSOR AND LESSEE POVs

Lessor POV Lessee POV
Operating  Lease payments = rent income -> straight-line method  Lease payments = rent expense -> usually straight-line
Lease method, but can be another method
 May or may not be applied by the lessee
 If the lease is short term (≤ 12 mos) and the asset is low
value (FV ≤ $5k)
General Recognition: General Recognition:
1. Cost of asset 1. Rent expense
2. Rent income 2. Security deposits
3. Initial direct costs paid by the lessor o Refundable: Receivable; until deposited back by
 o Added to the carrying value of the asset lessor
o Expensed over the lease term o Non-refundable: Prepaid rent expense; until
4. Executory costs lessor records the deposit as earned
o Depreciation, maintenance, insurance and taxes, 3. Lease bonus (prepayment)
etc. o Deferred charge = asset; amortized over the
o Expensed as incurred lease term (dr. deferred charge; cr. cash or a/p)
5. Security deposits 4. Leasehold improvements
o Refundable: Liability; until deposited back to the o Revert back to lessor at end of lease term; added
lessee to PPE/intangible assets
o Non-refundable: Unearned revenue; deferred
6. Lease bonus (prepayment)
o Unearned revenue = liability; income over the
lease term
Finance Lease Direct Finance Lease Lessee recognizes both:
 Financing business 1. Lease Liability
 Income = interest income 2. Right of use asset
Sales Type Lease
 Manufacturer or dealer LEASE LIABILITY
 Income = (1) gross profit & (2) interest income 1. Initial measurement:
1. Direct 1. Gross Investment PV of lease payments, discounted at (in order of priority):
o = Lease payments (Annual rent) + Guaranteed or 1. Implicit rate; or
unguaranteed residual value 2. Incremental borrowing rate
2. Net investment* o (+) Fixed future lease payments
o = Cost of asset + Initial direct costs paid by lessor o (+) variable lease payments
3. Unearned interest income o (+) Amounts expected to be payable under
o = Gross Investment – Net investment* residual value guarantees, if ‘reasonably certain’
4. Sales o (+) Option price, if ‘reasonably certain’
o Zero, nil o (+) Termination penalties, if ‘reasonably certain’
5. COGS
o Zero, nil 2. Subsequent measurement
6. Gross Profit o Amortized cost (carrying amount, beg. – principal
o Zero, nil payment)
2. Sales Type 1. Gross Investment o Interest is computed using the effective interest
method
 o Lease payments + Guaranteed or unguaranteed o Payments are allotted to both interest and
residual value reduction to lease liability
2. Net investment**
o = PV of lease payments + PV of residual value or RIGHT OF USE ASSET
option 1. Initial measurement (at cost):
3. Unearned interest income o (+) Initial measurement of lease liability
o = Gross Investment – Net investment** o (+) Initial direct costs paid by the lessee
4. Sales o (+) Lease payments made to lessor (e.g. lease
o Guaranteed residual value: Sales = Net bonus)
investment; or, FV of asset, whichever is lower o (-) Lease incentives
o Unguaranteed RV: Sales = Net investment; or, FV o (+) Est. dismantling, restoration, & removal costs
of asset, whichever is lower, less PV of 2. Subsequent measurement
unguaranteed RV o CV is measured under cost model (cost – acc.
5. COGS depreciation – acc. Impairment loss), or
o Guaranteed residual value: COGS = Cost of asset otherwise (revaluation/fair value model, as
+ Initial direct costs paid by lessor appropriate)
o Unguaranteed RV: COGS = Cost of asset + Initial
direct costs – PV of unguaranteed RV
6. Gross Profit
 = Sales – COGS

FINANCE LEASE COMPUTATION BREAKDOWN

Direct Finance Lease Sales Type Finance Lease
1. Gross Investment Step 1: Solve for annual rentals Step 1: Solve for annual rentals
Cost of asset xx Cost of asset xx
Add: Present value of residual value xx Add: Present value of residual value xx
Present value of annual rentals/lease xx Present value of annual rentals/lease xx
payments payments
Divided by: PV Factor xx Divided by: PV Factor xx
Annual Rentals/Lease payments xxx Annual Rentals/Lease payments xxx

Step 2: Solve for gross rentals Step 2: Solve for gross rentals
Gross rentals = Annual rentals x Lease term Gross rentals = Annual rentals x Lease term
 Step 3: Gross investment Step 3: Gross investment
Gross investment = Gross rentals + Residual value* Gross investment = Gross rentals + Residual value*

*Considered only if there is no transfer of ownership or *Considered only if there is no transfer of ownership or
purchase income purchase income
*if there is option price, it is added *if there is option price, it is added

2. Net Investment Cost of asset xx Present value of annual rentals xx

Add: Initial direct lease paid by lessor xx Add: PV of residual value or purchase xx
Net Investment xxx option
Net Investment xxx
3. Unearned Interest Gross investment xx Gross investment xx
Income Less: Net investment (xx) Less: Net investment (xx)
Unearned interest income xxx Unearned interest income xxx
4. Sales 0; nil Guaranteed residual value:
Sales = Net investment; or, FV of asset, whichever is lower

Unguaranteed RV:
Sales = Net investment; or, FV of asset, whichever is
lower, less PV of unguaranteed RV

5. COGS 0; nil Guaranteed residual value:

COGS = Cost of asset + Initial direct costs paid by lessor

Unguaranteed RV:
COGS = Cost of asset + Initial direct costs – PV of
unguaranteed RV
6. Gross Profit Gross Profit = Sales – COGS Gross Profit = Sales – COGS

Sale and Leaseback Transactions

 Seller – Lessee; Buyer – Lessor
 When the buyer would lease the asset back to the seller in a sale transaction, creating a lease transaction
 Previous rules on leases will apply, but the seller is the lessee, while the buyer is the lessor
 Buyer – Lessor Seller - Lessee
 Same as previous rules on lessor accounting  Right of use asset at commencement date
 Finance Lease o Equation:
 Operating Lease ROU =Carrying amount of asset ׿

*Right retained computation

 (+) PV of lease payments (lease liability)
 (+) Prepayments, if selling price < fair value
 (-) Additional financing, if selling price > fair value
o Total gain (= fair value – carrying amount)
 Operating lease – recognized in FULL
 Finance lease

Gain to be recognized:
Gain=Total gain ׿

*right transferred = fair value – right retained

Gain NOT to be recognized:

Gain=Total gain ׿

 Lease liability
o PV of the lease payments