LEASES
Accounting Theory
A lease is a contract for real or personal property between the lessor and the lessee for a determined period of
time. For an operating lease there is no change in ownership and the owner is not providing financing. The
lessee makes rent payments. A lease may be for a very short period or may continue for a very long period
including the entire service life of an asset. Leases are either operating leases or financing leases.
Operating Lease
The owner is responsible for the risks and rewards of ownership.
The rental income should include all costs and expenses including amortization and depreciation and making a
profit.
No special property rights or purchase rights or lease-purchase agreements are transferred.
The lease agreement is cancellable upon certain terms and conditions.
The lease is not a financing method for the lessee.
Accounting for the lessor is the rental method and the accounting for the lessee is the expense or non
capitalization method. In accordance with the matching principle both methods record income and expense on
the accrual basis of accounting.
When real property is leased the average of the rents for the entire lease are recorded each rent period. For the
lessor at the beginning of the lease the rent received will be less than the rental income. The net amount (debit)
is recorded as deferred rent receivable. For the lessee at the beginning of the lease the rents paid will be less
than the rent expense. The net amount (credit) is recorded as a deferred payable.
When there is a rent payment in advance such as a down payment the payment must be amortized over the life
of the lease. The amortization can be calculated by the straight line method or the present value method. The
advance payment is recorded by the lessor as a liability unearned rent income and by the lessee as an asset
prepaid rent expense. These accounts are amortized to rent income and rent expense respectively. When using
the present value method the amount of equal periodic payments over the term of the lease are calculated by
the present value of an annuity. An interest rate representing return on investment will have to decided.
Illustration Real Estate Operating Lease and Equipment Operating Lease
Financing Lease
Financing leases are most likely with companies engaged in the business of providing financing. The lessee is
using the lease to obtain financing. Financing leases are of a longer term than operating leases. The types of
financing leases are as follows:
Leases that provide special property rights.
Accounting for the lessor is the financing method and the accounting for the lessee is the capitalization method.
The lessor records a Receivable for the full amount of the present value of an annuity, removes the Property
Leased, and records Deferred Interest Income (unearned lease revenue) as the return on the investment. The
receivable is reported net with the unearned lease revenue. These accounts are recorded as current assets and
other assets. The unearned lease revenue is reclassified to lease revenue earned when each
installment payment is received.
The lessee records an asset Leasehold Rights (an intangible fixed asset), the Interest Expense (discount on lease
obligations) and a Payable for the full amount of the present value of an annuity. The payable is reported net
with the discount on the lease obligations. These accounts are recorded as current liabilities and long-term
liabilities. The discount on lease obligations is reclassified to interest expense or discount on lease obligations
when each installment payment is made. The leasehold rights is amortized to expense over the term of the
lease.
LEASES
Leases which are purchases - lease-purchase contracts.
Accounting for the lessor is the financing method and the accounting for the lessee is the capitalization method.
The lessor records a Note Receivable-Leases for the full amount of the present value of an annuity, removes the
Property Leased, and records Deferred Interest Income (unearned interest income) as the return on the
investment. The note receivable-leases is reported net with the unearned interest income. These accounts are
recorded as current assets and other assets. The unearned interest income is reclassified to interest
income earned when each installment payment is received.
The lessee records an asset Property Lease-Purchase (a fixed asset), the Interest Expense (prepaid interest) and
a Note Payable-Lease Purchase for the full amount of the present value of an annuity. The note payable-lease
purchase is reported net with the prepaid interest. These accounts are recorded as current liabilities and long-
term liabilities. The prepaid interest is reclassified to interest expense when each installment payment is made.
The property lease-purchase is depreciated to expense over the term of the lease.
Illustration Financing / Capitalization Lease
Financing Leases
Leases that provide special property rights.
Leases that provide special property rights. The lessor provides the property and equipment to the lessee who
makes installment payments in the form of rent. These payments include both principal and interest. The
special property rights are in the lease agreement and can include the following:
The lease should cover the entire useful life of the property.
The residual value of the property at the end of the lease is very small.
The lease is non cancellable.
The rent over the term of the lease provides a fair return on the owner's investment.
The cost of ownership ( taxes, insurance and maintenance) is transferred to the lessee.
The risks and rewards of ownership are transferred to the lessee without a formal transfer of title.
The property is returned to the lessor at the end of the lease.
With a lease-purchase agreement the property is not returned to the lessor at the end of the lease.
Leases which are purchases - lease-purchase contracts.
Leases which are purchases - lease-purchase contracts. The lessor provides the property and equipment to the
lessee and the lessee does not return it at the end of the lease. The lessee can make installment payments or
can purchase the property for the total amount of the installments. At any time the lessee can purchase the
property for the remaining balance of the installment payments. Lessee may sign a noninterest-bearing note
with the lease agreement. Leases which are lease purchases can include the following:
The initial term of the lease agreement or lease-purchase agreement is materially less than the useful life of the
property and the lessee has the option to renew the lease for the remaining useful life of the property.
The lessee has the right during or at the end of the lease to purchase the property.
The property is special needs property that was acquired by the lessor to meet the needs of the lessee.
The term of the lease covers the entire useful life of the property and the lessee pays the cost of ownership.
The lessee has guaranteed the obligations of the lessor regarding the property leased.
The lessee has treated the lease as a purchase for tax purposes.
LEASES
Sale and Leaseback
Sale and leaseback agreements are entered into to free up the equity in long-lived assets such as real estate. In
addition to the sales contract there is an agreement to lease back the asset sold. The fixed asset is sold for cash
and the owner agrees to make rental payments in order to continue to use the property. The rental payments
are tax deductible and the buyer's investment in the property is enhanced by the lease agreement. In
accordance with the full disclosure principle the details of any material sale and leaseback transaction should
be disclosed in the notes to the financial statements. Material gains or losses resulting from the sale of
properties which are the subject of sale and leaseback transactions together with the related tax effect should
be amortized over the life of the lease as an adjustment of the rental cost or if the leased property is capitalized
as an adjustment of depreciation.
Calculating the Amount of Rental Payments for Rental Real Estate and Other Property
Determining Rent Amount for Real Estate and Other Property by Present Value of an Annuity
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