Intermediate
Financial Accounting
Accounting for Leases
Accounting for Leases
According to FASB statement No. 13 ,
a lease is defined as “an agreement
conveying the right to use property,
plant, or equipment for a stated period
of time”.
Accounting for Leases 2
Accounting for Leases :(contd.)
A lease involves a lessee and a lessor.
A lessee acquires the right to use the
property, plant and equipment and a
lessor gives up the right.
A lease is a contractual agreement and
therefore the parties involved can
incorporate any provision in the contract.
All kinds of assets can be leased.
Among the most popular are
photocopies, computer, airplanes, and
warehouses. Accounting for Leases 3
Lessors (source: Kieso, Weygandt, and Warfield )
Lessors who own the property:
Banks: The largest lessors in the leasing
industry. They provide general finance for
companies. Examples: Wells Fargo, Chase, Citigroup.
Captive leasing companies: subsidiaries
whose primary business is to perform
leasing operations for the parent company
(i.e., structure lease contracts for the parent
companies and their customers). Examples:
Chrysler Financial (for Daimler-Chrysler), IBM Global
Financing (for IBM), Boeing Capital.
Accounting for Leases 4
Lessors (contd.)
Independents: leasing companies whose
primary business is to perform general
finance for other companies. Their market
share of leasing business has declined as
the other two types of lessor’s market share
has increased. Some independent lessors
have become the captive finance companies
for other companies without a leasing
subsidiary.
Accounting for Leases 5
Accounting for Leases :(contd.)
This chapter emphasizes the long-term
non-cancelable leases involving
depreciable personal property such as
equipment, machinery, trucks and
other movable assets.
Accounting for Leases 6
Accounting for Leases :(contd.)
The objectives of the chapter include:
1. Accounting for lessees:
a. Operating leases.
b. Capital leases:
.without bargain purchase option
.with bargain purchase option
. With guaranteed residual value
Accounting for Leases 7
Accounting for Leases :(contd.)
The objectives of the chapter include:
2. Accounting for lessors:
a. Operating leases.
b. Capital leases:
.direct-financing leases
.sales-type leases
Accounting for Leases 8
Advantages of Leasing from Lessees'
Viewpoint (source: Kieso and Weygandt)
1. Financing benefits:
a. The lease provides 100% financing (no
down payment is needed). For
companies with cash shortage, lease
is a good alternative to purchase;
b. The lease contract may contain fewer
restrictive provisions than other debt
agreement; and
c. The lease agreement creates a claim
that is against only the leased asset ,
not against all assets.
Accounting for Leases 9
Advantages of Leasing from
Lessees' Viewpoint :(contd.)
2. Risk benefit:
Reduce the risk of obsolescence.
3. Tax benefit:
Tax deduction may be accelerated since
it is often spread over the lease term
(rather than the economic life of the
property). The full cost of the leased
asset can be written off including the
part that relates to land.
Accounting for Leases 10
Advantages of Leasing from
Lessees' Viewpoint :(contd.)
4.Financial reporting benefit (off-balance-
sheet financing):
For an operating lease, the lease does
not add a liability or an asset to the
balance sheet, and therefore does not
affect financial ratios. By maintaining these
ratios, the company's borrowing capacity
can also be maintained.
Off-balance-sheet financing: acquiring the
right to use assets but not reporting the
assets and liabilities on the balance sheet
Accounting for Leases 11
Advantages of Leasing from
Lessees' Viewpoint :(contd.)
5. Billing benefit:
Leasing permits higher charges
because the interest element contained
in the rental payments is treated as an
expense.
6.Less Costly Financing:
The income tax savings on depreciation
expenses for the leasing company(the
lessor) may pass on to the lessee in the
form of a reduced rental payment.
Accounting for Leases 12
Advantages of Leasing from
Lessees' Viewpoint :(contd.)
An example of using leasing to achieve off
balance sheet financing: assuming that in
20X1, two identical companies, A and B,
have the following data prior to any new
acquisitions:
current assets $3,000,000
noncurrent assets 5,000,000
current liabilities 2,000,000
noncurrent liabilities 2,500,000
stockholders’ equity 3,500,000
Accounting for Leases 13
Advantages of Leasing from
Lessees' Viewpoint :(contd.)
On December 31, 20X1, A company
purchases an equipment with a 5-year life
costing $3,018,400 by signing a 5-year, 8%
note requiring $755,923 to be paid at the
end of each year staring December
31,20X2.
The payments include interests at 8% on the
beginning-of-year principal balance.The
remainder of each annual payment reduces
principal.
Accounting for Leases 14
Advantages of Leasing from
Lessees' Viewpoint :(contd.)
A company records the asset
purchased and the note payable. A's
financial data show the following
changes:
Accounting for Leases 15
Advantages of Leasing from
Lessees' Viewpoint :(contd.)
noncurrent assets: $5,000,000 + 3,018,400
= $8,018,400
current liabilities: $200,000 + 755,923 * 0.926
= $2,699,985
noncurrent liabilities: $2,500,000+ (3,018,400
- 699,985)
= $4,818,415
The rest remains unchanged.
Accounting for Leases 16
Advantages of Leasing from
Lessees' Viewpoint :(contd.)
Therefore;
Before Acquisition After acquisition
current ratio $3,000,000/$2,000,000 $3,000,000/2,699,985
=1.5 = 1.11
debt to
stockholder
equity $4,500,000/3,500,000 (2,699,985+4,818,415)
$3,500,000
= 1.29 = 2.15
Accounting for Leases 17
Advantages of Leasing from
Lessees' Viewpoint :(contd.)
The current ratio falls significantly(from 1.5
to 1.11) while the debt to stockholders’
equity ratio increases 67% after the
acquisition.
The rate of return on investment in 20X2
could also be impaired (due to the increase
of noncurrent assets).
These adverse impacts on financial ratios
will damage the borrowing capacity of A
company and may also affect it's ability to
sell stock.
Accounting for Leases 18
Advantages of Leasing from
Lessees' Viewpoint :(contd.)
On the other hand, assume that B
company leases identical equipment by
the use of a lease and agrees to pay
$755,923 rent each year for the next 5
years. If interest rate is 8%, the present
value of the equipment is $3,018,400.
If the lease is classified as a capital lease,
B records an asset and a liability and the
effects on it's B/S are the same as the
effects of purchase on A's B/S.
Accounting for Leases 19
Advantages of Leasing from
Lessees' Viewpoint :(contd.)
However, if the lease is classified as an
operating lease, B does not have to
record an asset or a liability.
Therefore, the financial ratios (i.e, the
current ratio) will be same as before the
acquisition.
In sum, two identical economic events
can have very different impact on key
ratios of financial statement(F/S).
Accounting for Leases 20
Advantages of Leasing from
Lessors' Viewpoint :(contd.)
1. A way of indirectly making a sale.
2. An alternative means of engaging in a
profit opportunity. The lease agreement
enables the lessor to earn a normal rate
of return (in a form of interest) on the
cost of leased asset.
Accounting for Leases 21
Classification of Personal property
Leases
A lease that transfers substantially all the
risks and benefits of ownership to the
lessee represents a purchase by the
lessee and a sale by the lessor and should
be treated as a capital lease (SFAS 13).
SFAS 13 provides criteria for determining
the classification of leases by both lessees
and lessors.
Accounting for Leases 22
Classification of Leases Involving Personal Property
General Criteria for classifying leases
Exhibit 1
Column A Column B
Criteria Applicable to Both Criteria Applicable to
Lessee and Lessor Lessor Only
a.The lease transfers ownership a.The collectibility of the
of the property to the lessee minimum lease payments
by the end of the lease term. is reasonably assured (i.e.,
b.The lease contains a bargain predictable).
purchase option b.No important uncertainties
c.The lease term is equal to or surround the amount of
greater than 75% of the unreimbursable cost yet to
estimated economic life of the be incurred by the lessor
leased property. under the lease.
d.The present value of the
minimum lease payments
(MLP) is equal to 90% or more
of the fair value of the leased
property to the lessor. Accounting for Leases 23
Classification by the lessee
Capital lease:
Lease that meets one or more of the criteria
in column A.
Lessee should treat capital lease as a
purchase of asset; recognize leased asset
and obligation under capital lease.
Operating lease:
Lease that does not meet any of the criteria
in Column A.
Accounting for Leases 24
Classification by the Lessor
Operating lease:
Lease that meets none of the criteria in
col. A, or does not meet both criteria in col.
B.
Direct Financing lease:
Lease that meets these three criteria:
1. One or more of the four criteria in col. A;
2. Both criteria in col. B; and
3. No manufacture's or dealer's profit.
Accounting for Leases 25
Classification by the Lessor (Contd.)
Sales-Type lease
Lease that meets these three criteria:
1.One of more of the four criteria listed in
col. A;
2. Both criteria in column B; and
3. Transaction involves a manufacturer
or dealer's profit (or loss) for the lessor.
Accounting for Leases 26
Classification by the Lessor :(contd.)
A profit for lessor exists when the fair
market value of the leased property is
greater than its cost or carrying value.
Items c and d of column A do not apply if
the beginning of the lease term falls within
the last 25% of the total estimated
economic life.
Accounting for Leases 27
Key Terms Related to Leases
Bargain Purchase Option
A provision allowing the lessee to purchase the
leased property at the end of the life of the lease at
a price so favorable that the exercise of the option
appears, at the inception of the lease, to be
reasonably assured.
Estimated Economic Life
The remaining life of leased assets for its intended
usage at the inception of the lease contract with
normal repair and maintenance.
Accounting for Leases 28
Key Terms Related to Leases
:(contd.)
Fair Value of Leased Property
Price for which the property can be sold in
an arm's length transaction between
unrelated parties.
For manufacturers and dealers, the fair
value is the selling price. For others, the fair
value is the cost of the asset to the lessor.
Accounting for Leases 29
Key Terms Related to Leases
:(contd.)
Minimum Lease Payments(MLP):
Payments that are required to be paid by the
lessee to the lessor over the life of the lease.
For a lease with a bargain purchase option
(BPO), the MLP include (for both lessee and
lessor):
1.The minimum periodic payments required
by the lease over the lease term; and
2. The payment required by the BPO.
Accounting for Leases 30
Key Terms Related to Leases
:(contd.)
Otherwise, the MLP include:
1. The minimum periodic payments, plus
2. Any guaranteed residual valuea, and
3. Any payments on failure to renew or
extend the lease if the agreement specifies
that the lease must be extended or
renewed.
Accounting for Leases 31
Key Terms Related to Leases
:(contd.)
a. for a lessee, the residual value must be
guaranteed by the lessee; for a lessor, it can
be guaranteed by either the lessee or a third
party.
Thus, a lessee's MLP could be less than a
lessor's when the residual value is
guaranteed by a third party.
Leased Assets for a lessee = the Present
Value (PV) of the MLP, Not to exceed the
fair market value of the asset.
Accounting for Leases 32
Key Terms Related to Leases
:(contd.)
Executory costs are ownership-type costs
(I.e., insurance, maintenance and property taxes).
It is expected to be paid by the party with the
ownership.
In the case of capital lease (lessee assumes
the ownership), if portion of the lease payment
is for the reimbursement of the executory
costs to the lessor, it should be subtracted
from MLP computation.
Accounting for Leases 33
I. Accounting for Leases -Treatment
of operating lease:
Terms and provisions of lease agreement between
landlord company (lessor) and tenant company
(lessee) dated January 1,1995
1.The lease term is 5 years. The lease is
noncancelable and requires equal rental payments
of $50,000 at the beginning of each year.
2.The cost, and also fair value, of the equipment to
the Landlord Company at the inception of the lease
is$400,000. The equipment has an estimated
economic life of 10 years and has a zero estimated
residual value at the end of this time.
Accounting for Leases 34
I. Accounting for Leases -Treatment
of Operating Lease: (contd.)
3.There is no guarantee of the residual value by the
Tenant Company.
4.The Landlord Company agrees to pay all executory
costs.
5.The equipment reverts to the Landlord Company at
the end of the 5 years;
6.The Tenant Company's incremental borrowing rate
is 12.5% per year.
7.For the Landlord Company, the interest rate implicit
in the lease is 12%.
8.The present value of an annuity due of 5 payments
of $50,000 each at 12% is 4.037349 * $50,000 =
$201,867.45
Accounting for Leases 35
Application of Criteria for Determination
of Lease Classification by Lessee
Classification Criteria Criteria Met? Remarks
1. Transfer of ownership at end of lease No
2. Bargain purchase option No
3. Lease term is 75% of economic life No It is 50%
4. Present value of lease payments is 90%
of fair value No The present
value is
$201,867.45,
or 50.5% of fair
value
Conclusion: the lease is an operating lease. It meets none of the
criteria.
Accounting for Leases 36
Journal Entries – Operating Lease for
Lessee
The only journal entry recorded by the lessee is:
1-1-95
Rent Expense 50,000
Cash 50,000
Similar entries will be recorded at the beginning of
1996 through 1999.
Under the operating lease, neither an asset nor a
liability is recognized.
Accounting for Leases 37
Accounting and Reporting by
Lessor
Types of leases classified by lessor:
1.Operating lease.
A lease that meets none of the criteria in
col. A or does not meet both criteria in col. B of
Exhibit 1.
2.Direct-financing lease.
A lease that meets one or more of the criteria in
col. A and both criteria in col. B of Exhibit 1.
Also the lease involves no manufacturer's or
dealer's profit.
Accounting for Leases 38
Accounting and Reporting by
Lessor:(Contd.)
3. A Sales-type lease.
A lease meets one or more of the criteria in
col. A and both criteria in col. B of Exhibit 1.
Also, the lease involves the recognition of a
manufacturer's or dealer's profit (or loss).
4. Leveraged lease.
A special three-party lease which is
considered to be a direct-financing lease.
Accounting for Leases 39
Operating Lease: (Lessor)
Under an operating lease, lessor retains
substantially all the risk and benefit of
ownership.
The leased equipment is reported on the
balance sheet in Property,Plant and
Equipment subsection entitled “Equipment
Leased to Others" and record depreciation.
The lessor usually pays the executory fees and
records them as operating expenses.
Accounting for Leases 40
The Accounting Treatment of an
Operating Lease -Lessor
Example: assume that landlord Company
(lessor) Leases a piece of equipment to Tenant
Co. (lessee) for 5 years under the terms
described on pages 32 and 33.
Tenant agrees to pay $50,000 at the beginning
of each year.
The equipment was purchased by Landlord at a
cost of $400,000. It has an estimated life of 10
years.
Accounting for Leases 41
Operating Lease- Lessor (contd.)
Landlord uses straight-line depreciation
method.
On 1/10/95, the lessor pays the annual
insurance premium of $2,000 and
on12/15/95, it pays for repair expense of
$1,500.
Assuming no initial direct costs, the
preceding information is recorded in the
following journal entries:
Accounting for Leases 42
Operating Lease-Lessor (contd.)
1. Purchase of equipment to be leased on
1/1/95:
Equipment leased to others 400,000
Cash (or Equipment)* 400,000
*if equipment was already owned
2.Collection of annual payment on operating
lease on 1/1/95:
Cash 50,000
Rental Revenue 50,000
(or Unearned rent)
Accounting for Leases 43
Operating Lease- Lessor (contd.)
3. Payments of annual insurance premium on 1/10/95:
(an executory cost)
Insurance expense 2,000
Cash 2,000
4.12/15/95
Repair expense 1,500
Cash 1,500
5. Recognition of Annual depreciation expense:
Depr. Exp.: Equip. leased to others 40,000
Acc. Depr.: Equip. leased to others 40,000
(400,000/10 = 40,000)
Accounting for Leases 44
II. Accounting for Leases -
Treatments for Capital Lease
When a lease is reported as a capital
lease, Lessee records an asset (i.e.,
leased equipment) and a liability (i.e.,
lease payable).
The amount of leased asset equals
liability and is calculated as the present
value of the minimum lease payments
(MLP).
Accounting for Leases 45
Accouning Treatments for Capital
Lease
In a capital lease, the lessee is usually
responsible for the executory costs.
If these costs are paid by the lessor,
these costs should be deducted from
the lease payments in computing the
present value of MLP.
Accounting for Leases 46
Discount Rate used in computing
the present value of MLP
In computing the PV of the MLP, lessee
should use the lower of
a.The lessee's incremental borrowing
rate, or
b.The lessor's implicit rate .
If b is unknown to lessee, lessee uses a.
The discount rate used by lessor is lessor’s
implicit interest rate.
Accounting for Leases 47
Discount Rate used in computing
the present value of MLP (cont.)
The present value of f MLP may be
different for a lessee and a lessor when
different discount rates are used in
computing the PV.
The lower the rate is, the greater the PV
of MLP.
Accounting for Leases 48
Depreciation or Amortization Criteria
for Leased Assets- for Lessee
Lease Agreement
No
Yes
Ownership Transferred?
No a.
Yes
Bargain Purchase Option Lessee Depreciates
No
Assets Over
Lease Term >= Yes Economic Life
75% of Asset’s Life
No b.
Yes
MLP 90% of FV Lessee Depreciates
No Assets
Lessor Depreciates Over Lease Term
Asset Over Economic Life
Accounting for Leases 49
Depreciation or Amortization Criteria
for Leased Assets – for Lessee(contd.)
a.Depreciates to the estimated residual
value.
b.Depreciates or amortizes to the lessee
guaranteed residual value (if there is any)
If not, depreciate to zero.
* Both "Amortization" and "depreciation term
can be used. FASB uses "Amortization “
more often due to leased asset is an
intangible.
Accounting for Leases 50
Examples and Accounting Treatments
for Capital Leases
Example A1: Equipment is leased under an
agreement without a transfer of ownership, a
bargain purchase option or a guaranteed RV.
Terms and provisions of lease agreement
between Gardner company (lessor) and Martin
company (lessee) dated January 1,1995:
1.The lease term is 4 years. The lease is
noncancelable and requires equal payments
of $32,923.45 at the end of each year.
Accounting for Leases 51
Example A1 (contd.)
2.The cost, and also fair value, of the
equipment to Gardner (lessor) at the inception
of the lease is $100,000. The equipment has
an estimated economic life of 4 years and
has a zero estimated residual value at the
end of lease term.
3.There is no guarantee of the residual value
by the Martin Company.
4.The Martin (lessee) Company agrees to pay
all executory costs.
Accounting for Leases 52
Example A1 (contd.)
5.The equipment reverts to Gardner at the end
of the 4 years;
6. Martin Company's (lesee) incremental
borrowing rate is 12.5% per year.
7.For Gardner Company (lessor), the interest
rate implicit in the lease is 12%. Martin
Company knows this rate.
8.Martin Company uses the straight-line
method to record depreciation on similar
equipment's.
Accounting for Leases 53
Example A1 (contd.)
9. The annual lease payment charged by
the lessor is calculated as follow:
$100,000 a/ 3.037349b = 32,923.45
a. If there is any RV or BPO, the P.V. of the RV
(guaranteed or not) or BPO should be
subtracted from the cost of $100,000 in
computing the lease payment.
b. P.V. of an ordinary annuity of $1 for 4
periods at 12% interest rate
Accounting for Leases 54
The Accounting Treatments for
Capital Lease-Lessor
10.The present value of an ordinary annuity of
four payments of $32,923.45 at 12% is
$100,000, calculated as follows:
3.037349 *$32,923.45 = $100,000.
11.The collectiblity of rental is reasonably
assured and no uncertainties involved in
the lease;
12. No initial direct costs;.
Accounting for Leases 55
The Accounting Treatments for
Capital Lease-Lessor (contd.)
The cost or the fair market value of the leased
equipment for the lessor can be derived as:
P.V. of lease payment a
+ P.V. of residual value (guaranteed or not)
_________
cost of leased equipment
a. if portion of the lease payment is to cover the
executory costs paid by the lessor, it should be
subtracted.
Accounting for Leases 56
Application of criteria to determine the lease
classification by Lessee and Lessor:
Classification Criteria Criteria Met? Remarks
1. Transfer of ownership at end of lease No Title reverts
to lessor
2. Bargain purchase option No
3. Leas term is 75% or more of economic life Yes 100% of
estimated life
4. Present value of MLP is 90% or more
of fair value Yes The Present
value is
$100,000, or
100% of fair
value
Accounting for Leases 57
The Accounting Treatment for
Capital Lease (Lessor):(contd.)
The lease is a capital lease for lessee because it
meets two of the four criteria under Column A (on
p21) .
The lease is a direct financing lease for lessor
because :
1. it meets two of the four criteria under
Column A and both criteria under
coloumn B (on p21) ; and
2. No dealer or manufacturer’s profit.
Accounting for Leases 58
Journal Entries for Example A1- Lessee
The journal entries to record the acquisition of the
leased asset, the amortization (depreciation) for 4
years by the lessee are as follows:
1. Initial Recording of capital lease on 1/1/95
Leased Equipment 100,000
Obligation Under Capital Lease 100,000
(or Lease Payable)
(PV of MLP = $32,923.45 * 3.037349 = 100,000)
Accounting for Leases 59
Journal Entries for Example A1 – Lessee (cont.)
2. First payment (on 12/31/95):
Interest Expense 12,000*
Obligation under C. L. 20,923
Cash 32,923
* 100,000 * 12% = 12,000
Interest Expense under effective interest method
Interest Expense = P.V. of liability. * effective
interest rate.
Accounting for Leases 60
Journal Entries for Example A1- Lessee (contd.)
3.Recognition of annual depreciation (or
amortization)of leased equipment on 12/31/95:
Depreciation Expense: Leased Equip.* 25,000
Acc. Depreciation: Leased Equip. 25,000
* The asset is amortized over the lease term because the lease
does not include a transfer of ownership or a BPO.
Depreciate to zero due to no guaranteed residual value.
Accounting for Leases 61
Journal Entries for Capital Lease (Lessee): (contd.)
Reporting:Balance Sheet (12/31/95)
Assets Liabilities:
PPE Current Liability:
Leased Equipment 100,000 Obligation under capital lease 23,434a
Acc. Depr.:Leased Equip (25,000) Long-Term Liability:
Obligation Under C.L: 55,643b
a. 32,923.45-(100,000-20,923)*0.12=23,434
b. 100,000 - 20,923 - 23,434 = 55,643
Accounting for Leases 62
Journal Entries for Example A1- Lessee (contd.)
4. Payment on 12/31/96:
Interest Expense 9,489.19a
Obligation Under Cap. Lease 23,434.26b
Cash 32,923.45
a. P.V. of liability at the beginning of 1996 * 12%
= (100,000-20,923.45) * 12%
= 9,489.12
b. 32,923.45 -9489.19 = 23,434.26
5. Depreciation Expense of 96:
Depreciation Expense: Leased Equip. 25,000
Acc. Depreciation : Leased Equip 25,000
Accounting for Leases 63
Journal Entries for Example A1- Lessee (contd.)
1997:Interest Expense 6,677.17
Obligation 26,246.38
Cash 32,923.45
Depreciation Expense : L. E. 25,000
Acc Depreciation: L.E 25,000
1998:Interest Expense 3,527.54
Obligation 29,395.91
Cash 32,923.45
Depreciation Expense : L. E. 25,000
Acc Depreciation: LE 25,000
Accounting for Leases 64
Journal Entries for Example A1- Lessee (contd.)
Selected account balance at the end of the
lease term:
Obligation (lease payable) = $0
Acc. Depreciation = $100,000
Leased Equipment = $100,000
Journal entry on 12/31/98:
Acc. Depre. 100,000
Leased Equip. 100,000
Accounting for Leases 65
ExhibitA1: Summary of lease payments and
interest expense of Example A1
Payments at End of Year
Annual Lease 12% on Unpaid Reduction of Obligation
Date Payment Obligation a Lease Obligation b Liability c
1-Jan-95 - - - $100,000.00
31-Dec-95 $32,923.45 $12,000.00 $20,923.45 79,076.55
31-Dec-96 32,923.45 9,489.19 23,434.26 55,642.29
31-Dec-97 32,923.45 6,677.07 26,246.38 29,395.91
d
31-Dec-98 32,923.45 3,527.54 29,395.91 0
Total 131,694 $31,694 $100,000
Accounting for Leases 66
Comparison of Capital Lease Expense and
Operating Lease Expense (pre-tax)
Year Operating Capital lease Difference Cumu.
Lease Expense (impact on Difference
Rental (Interest income) (impact on
Expense Expense R/E)
+Depre. Exp.)
1995 $32,923 (12,000+25,000) -$4.077 -$4,077
1996 $32,923 (9,489+25,000) -$1,566 -$5,643
1997 $32,923 (6677+25,000) $1,246 -$4,396
1998 $32,923 (3,528+25,000) $4,395 $0
Accounting for Leases 67
Comparison (contd.)
Capital lease expense is greater than that of
operating lease expense for 1995 and 1996.
However, this phenomenon is reversed in
1997 and 1998.
The income impact of lease capitalization is
negative for 1995 and 1996, but is positive
for 1997 and 1998.
The lease capitalization impact on retained
earnings is always negative during the lease
term and is zero when the lease term is up.
Accounting for Leases 68
Summary of Lease Payments and Interest
Expense of Martin company (contd.)
a. Column 5 at beginning of year * 12 %, the
effective interest expense
b. Column 2 - Column 3
c. Column 5 at beginning of year - Column 4
d. adjusted for rounded error of 0.03.
For capital leases, executory costs paid by the
lessee are recorded as operating expenses.
If these costs are paid by the lessor, they
should be deducted from the computation of
MLP.
Accounting for Leases 69
Journal Entries for Example A1- a direct financing
Lease for a Lessor:
The journal entries to record the lease of the
equipment and the receipts of 4 lease
payments for the lessor are as follows:
1. Initial Recording of capital lease on
1/1/95
Lease Receivablea 131,694
Leased Equipment b 100,000
Unearned Revenuec 31,694
Accounting for Leases 70
Example A1 – Lessor (cont.)
a. Lease Receivable (Gross Investment)=
annual Lease Payment x lease terms +
residual value (guaranteed or not) or BPO
b. Equipment = PV of lease receivable at
lessor’s rate = cost of leased asset=fair
market value of lease asset under direct
financing
c. Unearned interest = Lease Receivable –
PV of lease receivable
Accounting for Leases 71
Example A1 – Lessor (contd.)
Other notes:
Net Investment =lease Receivable –
Unearned Interest = lease liability of
lessee
Interest revenue for lessor = int. rate x
net investment = interest exp. Of
lessee=int. rate * lease lia. of lessee
Accounting for Leases 72
Example A1 –Lessor (contd.)
For lessee:
MLP = lease payment + guaranteed RV by
lessee only or BPO.
Leased Asset = PV of MLP at the lower of
two interest rates.
Lease liability = leased assets.
Interest Exp. of lessee = int. rate x lease
liablity = interest revenue of lessor.
Accounting for Leases 73
Journal Entries for Example A1 ( a direct financial
Lease for a Lessor (contd.)
2. First payment received by lessor (on 12/31/95):
Cash 32,923*
Lease Receivable 32,923
Unearned Interest 12,000
Interest Revenue 12,000
* 100,000 (net invest. = lease lia.)* 12% = 12,000
see p64 and p75
Accounting for Leases 74
Example A1- Lessor (contd.)
Reporting LR is divided into current and
noncurrent portions for B/S reporting purposes.
Current Noncurrent Total LR
32,923.45 a 65,840.90 b 98,770.35
(9,489.19) c (10,204.60) (19,693.80)
Net Inv. 23,434.26 55,636.30 79,076.55
a. The lessee's annual payment of 1996
b. 98,770.35 -32,923.45
c. 79,076.55 (Net Investment) * 12%
Accounting for Leases 75
Journal Entries for Example A1-Lessor (contd.)
1996:
Cash 32,923
Lease Receivable 32,923
Unearned Interest 9,489
Interest Revenue 9,489
1997:
Cash 32,923
Lease Receivable 32,923
Unearned Interest 6,677
Interest Revenue 6,677
Accounting for Leases 76
Journal Entries for Example A1-Lessor (contd.)
1998:
Cash 32,923
Lease Receivable 32,923
Unearned Interest 3,528
Interest Revenue 3,528
Accounting for Leases 77
Journal Entries for Example A1- Lessor (contd.)
At the end of the lease term,
lease receivable =0 and
unearned revenue=0.
Assume the market value of the reverted
leased asset is $2,000, the following entry will be
recorded(due to zero residual value is assumed
for the leased asset) by the lessor:
Equipment 2,000
Gain 2,000
Accounting for Leases 78
Summary of lease payments received and
interest revenue : Exhibit A1-Lessor
Receipts at End of Year
Annual Lease Revenue at of Net Lease Unearned
Payment 12% on Net Investment Receivable Interest Net
Date Received Investment a Recovered b Leases d Investment e
1/1/1995 $131,693.80 $31,693.80 $100,000.00
1/1/1995 $32,923.45 $12,000.00 $20,923.45 98,770.35 19,693.80 79,076.55
1/1/1996 32,923.45 9,489.19 23,434.26 65,846.90 10,204.61 55,642.29
1/1/1997 32,923.45 6,677.07 26,246.38 32,923.45 3,527.54 29,395.91
1/1/1998 32,923.45 3,527.54 f 29,395.45 0 0 0
total 131,693.00 31,693
Accounting for Leases 79
Summary of lease payments received and
interest revenue earned by Gardner company
(Lessor): Exhibit A1-Lessor
a. Column 7 at beginning of year *
12%
b. Column 2 - Column 3
c. Annual lease payment * Number of
years remaining on lease
d. Previous balance - Column 3
e Column 5 - Column 6 =lease liability
of lessee
Accounting for Leases 80
The Accounting Treatments for
Capital Lease-Lessor(contd.)
The MLP for both lesser and lessor
equals:
The annual payments + guaranteed
residual value a or BPO
a. For a lessee, the RV needs to be
guaranteed by the lessee.
For a lessor, the RV can be guaranteed
by a lessee or by a third party.
Accounting for Leases 81
The Accounting Treatment for
Capital Lease -Lessor
Thus, it is possible that a lease is
reported as an operating lease by the
lessee while is reported as a capital
lease by the lessor.
Method: with a large amount of RV
guaranteed by a third party.
Accounting for Leases 82
Example A1 – Lessor (using the method in the
5th Edition of the Textbook)
1. Initial Recording of capital lease on 1/1/95
Lease Receivable 100,000
Leased Equipment 100,000
2. First payment received by lessor (on
12/31/95):
Cash 32,923
Lease Receivable 20,923
Interest Revenue 12,000
Accounting for Leases 83
Example A1-Lessor (5th Edition Method)
1996:
Cash 32,923
Lease Receivable 23,434
Interest revenue 9,489
1997
Cash 32,923
Lease Receivable 26,246
Interest Revenue 6,677
Accounting for Leases 84
Example A1-Lessor (5th Edition
Method)
1998:
Cash 32,923
Lease Receivable 29,395
Interest Revenue 3,528
Assume the market value of the reverted
leased asset is $2,000, the following entry will
be recorded(due to zero residual value is
assumed for the leased asset) by the lessor:
Equipment 2,000
Gain 2,000
Accounting for Leases 85
Capital Leases : Payments in Advance
with Zero RV – Example A2
Example A2:
Assume all the lease provisions are the
same as in example A1 except that the
lease payments are made at the
beginning of each year. Also, the cost
also the fair value of the equipment is
$112,000, not $100,000.
Accounting for Leases 86
Capital Leases : Payments in Advance
with Zero RV – Example A2
Lessor will compute the lease payment as
follows:
$112,000/ 3.401831a = 32,923.42
a. P.V. of an annuity due of $1 for 4 periods
at 12% discount rate.
P.V. of MLP for both lessee and lessor =>
$32,923.42 x 3.401831 = $112,000.
The lease is a capital lease for lessee and a
direct financing lease for lessor.
Accounting for Leases 87
Journal Entries for Example A2-
Lessee
1. Initial Recording
Leased Equip under C.L. 112,000
Obligation under C.L. 112,000
2. Payment on 1-1-95 (the inception of the lease)
Obligation under C.L. 32,923.45
Cash 32,923.45
3. Recording of Depreciation on 12-31-95
Depreciation Expense:
Leased Equipment 28,000
Acc. Depreciation: Leased Equipment 28,000
Accounting for Leases 88
Example A2 –Lessee (Cont.)
4. Recording accrued Interest Expense:
12-31-95 Interest Expense 9,489.19a
Accrued Interest on Obli. 9489.19
a. (112,000 -32,923,45) * 12%
5.Second annual payment in advance on 1/1/96:
Accrued Interest on Obligation 9,489.19
Obligation under C.L. 23,434.26
Cash 32,923.45
Accounting for Leases 89
Example A2 -Lessee
Similar Entries will be recorded for 12/31/96,
1/1/97, 12/31/97, and 1-1-98.
Journal entry on 1/1/98 (the last MLP):
Accrued Interest 3,527
Obligation under C.L. 29,395
Cash 32,923.45
Note: No accrued interest on 12/31/98 due to the lease
liability has been paid off on 1/1/98.
12/31/98 Acc. Depre. 112,000
Leased Equip. 112,000
Accounting for Leases 90
Summary of lease Payments and Interest
Expense of Martin company (Lessee):
Exhibit A2: Payments in Advance
(1) (2) (3) (4)
Interest at 12%
Annual Lease on Unpaid Balance of Lease
Date Payment Obligation a Obligation Liability b
January 1, 1995 Before the initial lease payment $112,000.00
January 1, 1995 $32,923.45 79,076.65
December 31, 1995 $9,489.19
c
January 1, 1996 32,923.45 55,642.29
December 31, 1996 6,677.07
January 1, 1997 32,923.45 29,395.91
December 31, 1997 3527.54 e
January 1, 1998 32,923.45 0
Total $131,694 19,694
Accounting for Leases 91
Journal Entries for Example A2 -
Payments in Advance with zero RV-
Lessor
1. Initial Recording
Lease Receivable 131,694
Equipment 112,000
Unearned Interest 19,694
2. Payment on 1/1/95 (at the inception of the lease)
Cash. 32,923.45
Lease Receivable 32,923.45
3. Recognize the interest on 12/31/95
Unearned Interest 9,489
Interest Revenue 9,489
Accounting for Leases 92
Example A2 - Lessor(Contd.)
4. The following entry will also be recorded on 1/1/96
,1/1/97 and 1/1/98
Cash. 32,923.45
Lease Receivable 32,923.45
5. Interest revenue will also be recognized on
12/31/96,and 12/31/97 (information is based on p84) :
96 Unearned Interest 6,677
Interest Revenue 6,677
97 Unearned Interest 3,528
Interest Revenue 3,528
Accounting for Leases 93
Example A2 – Lessor (contd.)
At the end of lease term:
Lease Receivable = 0
Unearned Interest =0
When the lease asset is reverted back to the
lessor on 1/1/99,the following entry will be
recorded if the market value of the leased
equipment is $300:
Equipment 300
Gain on Capital Lease 300
Accounting for Leases 94
Guaranteed Residual Value
Guaranteed residual value (RV):
The RV of the leased property which is
guaranteed by the lessee (or by a third
party not related to the lessor).
For lessee, only when the RV is
guaranteed by the lessee, it would be
included in the MLP. For lessor, the RV
will be included in the MLP as long as it
is guaranteed .
Accounting for Leases 95
Guaranteed Residual Value (contd.)
If the residual value is guaranteed,when the
fair market value of the leased property at
the end of the lease term is less than the
guaranteed amount, the guarantor has to
pay the difference to the lessor.
Lease provision will include guaranteed
residual value only if no ownership
transfer and no BPO.
Accounting for Leases 96
Payments in Advance with
Guaranteed Residual Value
Example A3:
Assume all the lease provisions are the
same as in Example A2 except that
there is a guaranteed residual value of
$1,000 by the lessee. Also, the cost
also the fair value of the equipment is
$112,635.5, not $100,000 or $112,000.
Accounting for Leases 97
Payments in Advance with
Guaranteed Residual Value (contd.)
A Lessor calculates the lease payment as:
(Cost – PV of residual Value)a/ 3.401831 =>
(112,635 - 1,000 x 0.6355)/3.401831= 32,923
a. guaranteed by anyone or not guaranteed
Residual value (RV) is used as a factor to
determine the amount to be recovered from
the lessee.
Major factors determining the implicit interest
rate of a lessor: the risk of the lessee,
whether the RV is guaranteed and the
conditions of the credit market.
Accounting for Leases 98
Payments in Advance with
Guaranteed Residual Value (contd.)
P.V. of MLP for both lessee and lessor is =>
$32,923.42 * 3.401831+$1,000 * 0.6355
= $112,635.5
The lease is a capital lease for lessee and a
direct financing lease for lessor.
Accounting for Leases 99
Journal Entries for Lessee-Example
A3
1. Initial Recording
Leased Equip under C.L. 112,635.5
Obligation under C.L. 112,635.5
2. Payment on 1-1-95 (the inception of the lease)
Obligation under C.L. 32,923.45
Cash 32,923.45
3. Recording of Depreciation on 12-31-95 (similar entr
will be performed for 96,97 and 98)
Depreciation Expense:
Leased Equipment (112635-1,000)/4 27,909
Accounting Equipment
Acc. Depreciation: Leased for Leases 27,909100
Journal Entries for A3- Lessee (contd.)
4. Recording accrued Interest Expense:
12-31-95 Interest Expense 9,565.a
Accrued Interest on Obli. 9565.
a. (112,635.5 -32,923,45) * 12%
5. 2nd annual payment in advance on 1/1/96:
Accrued Interest on Obligation 9,565
Obligation under C.L. 23,358
Cash 32,923
Accounting for Leases 101
Payments in Advance with
Guaranteed Residual Value-lessee (contd.)
6. Recording accrued Interest Expense:
12-31-96 Interest Expense 6762a
Accrued Interest on Obli. 6762.
a. (112,635.5 -32,923,45-23,358) * 12%
7.3rd annual payment in advance on 1/1/97:
Accrued Interest on Obligation 6762
Obligation under C.L. 26161
Cash 32,923
Accounting for Leases 102
Payments in Advance with
Guaranteed Residual Value-Lessee (contd.)
8. Recording accrued Interest Expense:
12-31-97 Interest Expense 3623a
Accrued Interest on Obli. 3623
a. (112,635.5 -32,923,45-23358-26161) * 12%
9.4th annual payment in advance on 1/1/98:
Accrued Interest on Obligation 3623
Obligation under C.L. 29300
Cash 32,923
Accounting for Leases 103
Payments in Advance with
Guaranteed Residual Value –Lessee (cont.)
12/31/98:
Interest Exp. 107a
Accrued Interest 107
a. (112,635.5 -32,923,45-23358-26161-29300)
* 12% = 107
1/1/99 (if FV of leased asset greater or equal
$1,000)
Accrued Interest 107
Obl. Under C.L. 893
Accumulated Depreciation 111,635
Leased Equip. 112,635
Accounting for Leases 104
Payments in Advance with
Guaranteed Residual Value-lessee (contd.)
1/1/99 (if FV of leased asset = $300)
Accrued Interest 107
Obl. Under C.L (or lease payable) 893
Accumulated Depreciation 111,635
Leased Equip. 112,635
Loss from Guaranteed RV 700
Cash 700
Accounting for Leases 105
Payments in Advance with Residual Value
Guaranteed by a third party or not Guaranteed-
lessee
If the residual value is not guaranteed or
guaranteed by a third party, the component
of MLP is only the annual lease payment.
Residual value is excluded from MLP for
lessee.
The accounting treatment for lessee is the
same as in the case of zero residual value
(I.e., A2) if it is still qualified as a capital
lease.
Accounting for Leases 106
Summary of lease Payments and Interest
Expense of Martin company (Lessee):
Exhibit AA3: Payment in Advance with GRV
Date lease payme. Accured Int. Bal. Of lease pay.
January 1, 1995 $112,635.00
January 1, 1995 $32,923.45 79,712.00
December 31, 1995 $9,565.44
January 1, 1996 32,923.45 c 56,354.00
December 31, 1996 6,762.48
January 1, 1997 32,923.45 30,193.00
December 31, 1997 3,623.00
January 1, 1998 32,923.45 $893.00
12/31/1998 $107.16
Total $131,693.80 20,058.08
Accounting for Leases 107
Journal Entries of Example A3
(Payment in Advance with Guaranteed
Residual Value by Lessee) -Lessor
1. Initial Recording
Lease Receivable. 132,692a
Equipment 112,635.5b
Unearned Int. 20,053
a. 32,923 x 4 +1,000 (guaranteed RV) (RV will be
included regardless guaranteed or not)
b. PV of lease payment + PV of RV or BPO (= cost)
2. Payment on 1-1-95 (at the inception of the lease)
Cash. 32,923.45
Lease Receivable 32,923.45
Accounting for Leases 108
Journal Entries for A3 -Lessor
4. Recording accrued Interest revenue on 12/31/95:
Unearned Interest 9,565.a
Interest rev. 9565
a. Accrued int. =net investment *12% = interest
expense (see Exhibit on p99)
b. Accrued interest will be recorded for 12/31/96
12/31/97, and 12/31/98 (see Exhibit on p99)
Accounting for Leases 109
Journal Entries for A3 -Lessor
4. Recording accrued Interest revenue on
12/31/96, 12/31/97 and 12/31/98:
96: Unearned Interest 6,762
Interest rev. 6,762
97: Unearned Interest 3,623
Interest rev. 3,623
98: Unearned Interest 107
Interest rev. 107
Accounting for Leases 110
Example A3 (Payments in Advance with
Guaranteed Residual Value by Lessee) -
lessor (contd.)
5. Second lease payment on 1/1/96:
Cash 32,923
Lease Receivable 32,923
Similar entry will be recorded on 1/1/97 and
1/1/98
Accounting for Leases 111
Example A3 (Payments in Advance with
Guaranteed Residual Value) -lessor (contd.)
At the end of the lease term, the Lease
Receivable = $1,000 (the guaranteed RV)
and the Unearned Interest = 0.
The following entry will be recorded when
the leased asset is reverted back to the
lessor with a market value of $700:
Equipment 700
Cash 300
Lease Receivable 1,000
Accounting for Leases 112
Payments in Advance with
Guaranteed Residual Value-lessor
(contd.)
The difference of $300 will be paid by
whoever (the lessee or a third party)
guarantees the residual value.
If the residual value is not guaranteed
by anyone, the cash account will be
replaced by a loss account.
Therefore, JE for lessors are the same
regardless whether the RV is
guaranteed or not.
Accounting for Leases 113
Payment in Advance with BPO
Example A4: Assume all the lease provisions are
the same as in example A2 except that there is a
bargain purchase option at $1,000 with the eco. life
of the leased asset increased from 4 to 10 years.
The expected (not guaranteed) residual
value is $2,635.5. The cost also the fair
value of the equipment is $112,635.5.
P.V. of MLP =
$32,923.42 * 3,401831+$1,000 * 0.6355
= $112,635.5 = 100% of the cost
The lease is a capital lease for the lessee and
a direct financing lease for the lessor.
Accounting for Leases 114
Journal Entries for A4 (Payment in
Advance with BPO) - Lessee
1. Initial Recording
Leased Equip under C.L. 112,635.5
Obligation under C.L. 112,635.5
2. Payment on 1-1-95 (the inception of the lease)
Obligation under C.L. 32,923.45
Cash 32,923.45
3. Recording of Depreciation on 12-31-95 (similar entr
will be recored for 96,97 and 98)
Depreciation Expense:
Leased Equipment (112635-2635/10) 11,000
Accounting Equipment
Acc. Depreciation: Leased for Leases 11,000 115
Journal Entries for A4 (Payment in
Advance with BPO)-Lessee (contd.)
4. Recording accrued Interest Expense:
12-31-95 Interest Expense 9,565.a
Accrued Interest on Obli. 9565.
See Exhibit on p97 for interest information.
5. 2nd annual payment in advance on 1/1/96:
Accrued Interest on Obligation 9,565
Obligation under C.L. 23,358
Cash 32,923
Accounting for Leases 116
Journal Entries for A4 (Payment in
Advance with BPO)-Lessee (contd.)
6. Recording accrued Interest Expense:
12-31-96 Interest Expense 6,762.a
Accrued Interest on Obli. 6,762
a see P97 for interest information.
7. Third lease payment on 1/1/97:
Accrued Interest on Obligation 6,762
Obligation under C.L. 26,161
Cash 32,923
Accounting for Leases 117
Payments in Advance with BPO
(contd.)-Lessee
8. Recording accrued Interest Expense for ,
12/31/97:
12-31-97 Interest Expense 3,623
Accrued Interest on Obli. 3,623
9. 4th payment on 1/1/98 :
Accrued Interest on Obligation 3,623
Obligation under C.L. 29,300
Cash 32,923
Accounting for Leases 118
Payments in Advance with BPO
(contd.)-Lessee
10. Recording accrued Interest Expense for ,
12/31/98:
12-31-98 Interest Expense 107
Accrued Interest on Obli. 107
Accounting for Leases 119
Payments in Advance with BPO
(contd.) -Lessee
1/1/99 (Lessee exercises the BPO by paying
$1,000)
Accrued Interest 107
Obl. Under C.L (or lease payable) 893
cash 1,000
Equip. 112,635
Leased Equip. 112,635
Accounting for Leases 120
Payment in Advance with BPO -
Lessor
1. Initial Recording 1/1/95
Leased Receivable . 132,692
Equipment . 112,635
Unearned Int. 20,057
2. Payment on 1-1-95 (at the inception of the lease)
Cash. 32,923.45
Lease Receivable 32,923.45
Accounting for Leases 121
Payment in Advance with BPO -
Lessor
Similar entries as in the case of guaranteed RV
(A2b) would be recorded for 1/1/96,1/1/97,1/1/98
(receipts of lease payments), 12/31/95, 12/31/96,
12/31/97 and 12/31/98 (recognition of accrued
interest revenue).
At the end of lease term, Lease Receivabe =
1,000, Unearned Revenue =0 and the following
entry will be recorded by the lessor:
Cash 1,000
Lease Receivable 1,000
Accounting for Leases 122
BPO Is Exercisable before the End
of the lease Term
For accounting purposes, the lease life
ends when the BPO becomes
exercisable.
Therefore, the lease term needs to be
set to end when BPO becomes
exercisable.
The PV of MLP needs to be calculated
accordingly.
Accounting for Leases 123
Lessors' Initial Direct Costs
Initial direct costs are costs that result
directly from acquiring a lease. It would not
have been incurred had that lease
transaction not occurred
For example, costs related to evaluating
the lessee's financial condition, costs of
negotiating terms, preparing and processing
lease documents, and closing the transaction
Accounting for Leases 124
Lessors' Initial Direct Costs (cont.)
For an operating lease, these costs are
recorded as a prepaid asset and are allocated
over the lease term as operating expense(in
proportion to the rental received) .
Accounting for Leases 125
Lessors' Initial Direct Costs (cont.)_
For a capital lease
a. direct financing type: these costs are
deferred and allocated over the lease
term (matching principle).
b. a sales type lease: these costs are
expensed at the inception of the lease
because sales revenue is recognized at
the inception.
Accounting for Leases 126
Lessors' Initial Direct Costs (cont.)_
In addition, employees' compensation and
benefits associated with the time spent on
performing those activities should also be
included in as part of the direct costs.
All other lease related costs (i.e., advertising,
serving existing leases, unsuccessful lease
origination, supervision and administration)
are expensed as incurred.
Accounting for Leases 127
Lessors' Initial Direct Costs (cont.)_
The lessor needs to determine a new (lower)
implicit rate that will discount the remaining
future minimum lease payments to the net
investments as of the inception of the lease.
Assuming the lessor incurred $5,000 of initial
direct costs on a direct financing lease, it will
record the costs as follows:
Unearned interest: Lease 5,000
Cash (or A/P) 5,000
Accounting for Leases 128
Lessors' Initial Direct Costs (cont.)_
Consequence: The debiting of unearned
interest for the direct costs will increase net
investment and decrease the implicit rate
(due to future cash flows remain
unchanged).
The lower rate would result in less interest
revenue recognition each period and achieve
the goal of deferring direct costs and
including them as a reduction of income over
the life of the lease.
Accounting for Leases 129
Sales-Type Leases (for lessor)
The major differences between a sales-
type lease and a direct financing lease are:
a. the presence of a manufacturer's or
dealer's profit or loss in a sales-type
lease, and
b. the accounting for initial direct costs.
Accounting for Leases 130
Sales-Type Leases (lessor)
The manufacturer's or dealer's profit is
measured as the difference between
(1) the present value of MLP (net of
executory costs), and
2) the cost or carrying value of the asset
plus the initial direct costs less the present
value of the unguaranteed residual value
accruing to the benefit of lessor.
Accounting for Leases 131
Sales-Type Leases (lessor):(contd.)
The accounting treatment for a sales-type
lease is the same as for a direct financing
lease except for recognizing the profit at the
inception of the lease.
Example B1: on 1/1/95, the York Company (the
lessor) leases an equipment to the Lake
Company (the lessee) with the terms and
provisions as indicated in the following slides:
Accounting for Leases 132
Example for Sales-type Leases (Lessor)
1.The cost of the equipment is $120,000. The
fair market value is $190,008.49.
2.No initial direct costs are incurred by the York
Company.
3.The term of the lease is 10 Years, with annual
payments of $30,000* received at the
beginning of each year. The estimated
economic life of the equipment is also 10
years.
*Lessor's computation of the lease payment:
(190,008 - PV of BPO $500)/6.3283 = 30,000
Accounting for Leases 133
Sales-type Leases (Lessor)
4.The Lake Company agrees to absorb all
executory costs.
5.The Lake Company is given an option to buy
the equipment at the end of the lease term at
$500.
6.The interest rate implicit in the lease is 12%.
7.The present value of 10 payments of $30,000
at 12% on an annuity basis plus the present
value of the bargain purchase option is
$190,008.49,calculated as follows:
Accounting for Leases 134
Sales-type Leases (Lessor)
Present value of 10 rents in
advance at 12% (6.3283 * $30,000) = 189,847.50
Plus: Present value of $500
discounted at 12% (0.321973 * $500) = 160.99
Total present value = $190,008.49
8.The collectibility of the payment is reasonably
assured, and there are no uncertainties involved
in the lease.
Accounting for Leases 135
Application of criteria for determination of lease
classification by York company (lessor)
Classification Criteria Criteria Remarks
Met?
Group I No
1. Transfer of ownership Yes
2. Bargain purchase option Yes
3. Lease term is 75% of Yes 100% of life
economic life
4. Present value of lease Yes The present value is
payments is 90% of fair $190,008.49, or 100%
value of estimated fair value
Group II
1. Collectibility reasonably Yes
assured
2. No uncertianties Yes
Accounting for Leases 136
Application of criteria for determination of lease
classification by York company (lessor):(contd.)
Conclusion: The lease is a sales-type
lease. Since appropriate criteria are met
and there is a manufacturer's or dealer's
profit.
The amount used as the selling price
($190,008.49) exceeds the cost ($120,000).
That is, the present (fair) value of the lease
payments is greater than the cost of the
property.
Accounting for Leases 137
Journal Entries for Sales-type Lease
(Lessor)
Assuming that the York Company (the lessor)
uses the perpetual Inventory system. it
records the information relevant to the lease
as follows:
1.Initial Recording of the sales-Type lease
on 1/1/95:
Accounting for Leases 138
Journal Entries for Sales-type Lease
(Lessor) (Contd.)
1/195
Lease Receivable 300,500
Cost of Goods Sold 120,000
Sales Revenue* 190,008.49
Unearned Interest: Lease**110,491.51
Equipment Held for Lease 120,000
* Sales revenue=PV of lessor's MLP. Thus, Sales
reveue= P.V. of lease receivable(LR)=fair value of
leased assets if all R.V. is guaranteed.
**Unearned int. = LR - P.V. of LR (or fair value of
leased assets). This is always true regardless RV is
guaranteed or not.
Accounting for Leases 139
Journal Entries for Sales-type Lease
(Lessor) (Contd.)
If portion of the RV is unguaranteed,
both the cost of goods sold and the
sales revenue accounts will be
reduced by the PV of the unguaranteed
RV (see P15-9).
The unguaranteed RV is treated as the
portion of the asset which is not sold.
Accounting for Leases 140
Journal Entries for Sales-type Lease
(Lessor) (Contd.)
2.Collection of first annual lease payment on
1/1/95:
Cash 30,000
MLPR 30,000
3. Recognition of interest revenue on
12/31/95:
Unearned Interest: Lease 19,201.02*
Interest Revenue 19,201.02
* [(300,500 - 30,000) - 110,491.51] * 12%
Accounting for Leases 141
Journal Entries forSales-type Leases
(Lessor) (Contd.)
The journal entries for the next 9 years
for the lessor will follow similar pattern as
to the entries of 1995.
After the entries for the 10th year are
made, the balance of LR (net investment)
on 12/31/2004 will be $500 (Exhibit 10):
Journal entry on 12/31/04:
Cash 500
Lease Receivable 500
Accounting for Leases 142
Other Comments Related to Sales-Type Leases
The lessor does not record any
depreciation on the leased asset since a
sale is deemed to have taken place
(due to BPO price is so low).
The lessee will depreciate the leased
asset and pay for the executory costs.
Accounting for Leases 143
Other Comments Related to Sales-Type Leases
Initial Direct Costs (IRD) Involved in a Sales-
Type Lease:
The IRD under the sales-Type lease should
be expensed at time of occurrence in order
to match with the revenue recognition at the
inception of the lease.
This can be done by including these costs in
the cost of goods sold or as a selling
expense.
Accounting for Leases 144
Exhibit for Sale-Type Lease
(1) (2) (3) (4) (5) (6)
Annual Lease Interest Unearned Net
Date Payment Received Revenue (12% * N.I) MLPR Interest (N.I) Investment
1/1/95 - - 300,500 110,491.51 190,008.49
1/1/95 30,000 - 270,500 110,491.51 160,008.49
12/31/95 - 19,201.02 270,500 91,290.49 179,209.51
1/1/96 30,000 - 240,500 91,290.49 149,209.51
12/31/96 - 17,905.14 240,500 73,385.35 167,114.60
1/1/97 30,000 - 210,500 73,385.35 137,114.65
12/31/97 - 16,453.76 210,500 56,931.59 153,568.41
1/1/98 30,000 - 180,500 56,931.59 123,568.41
12/31/98 - 14,828.21 180,500 42,103.38 138,396.62
1/1/99 30,000 - 150,500 42,103.38 108,396.62
12/31/99 - 13,007.59 150,500 29,095.79 121,404.21
1/1/00 30,000 - 120,500 29,095.79 91,404.21
12/31/00 - 10,468.51 120,500 18,127.28 102,372.72
1/1/01 30,000 - 90,500 18,127.28 72,372.72
12/31/01 - 8,684.73 90,500 9,442.55 81,057.45
1/1/02 30,000 - 60,500 9,442.55 51,051.45
12/31/02 - 6,126.89 60,500 3,315.66 57,184.34
1/1/03 30,000 - 30,500 3,315.66 27,184.34
12/31/03 - 3,262.12 30,500 53.54 30,446.46
1/1/04 30,000 - 500 53.54 446.46
12/31/04 - 53.57 500
Accounting for Leases 0 500145
Reporting on Statement of Cash Flows
Operating Leases: both lessee and lessor
report cash flows related to lease payments
as cash flows from operating activities.
Capital Leases:
Lessee: reports cash flows for payments
toward interest exp. as cash flows from
operating activities and reports the payments
toward the principal (i.e., lease payable) as
cash flows from financing activities.
Accounting for Leases 146
Reporting on Statement of Cash Flows
(contd.)
Capital Leases (contd.):
Lessor: reports cash flows of the interest
portion as cash flows from operating
activities and the cash receipts toward the
principal portion as cash flows from
investing activities.
Accounting for Leases 147
Contingent Rentals
Lease payments may be increased if a
future event occurs (i.e., an increase of
revenue over 30%; or an increase of usage
on the leased property).
The potential incremental lease payments
are referred to as contingent rentals.
Contingent rentals are not included in the
MLP because they are not determinable at
the inception of the lease.
Accounting for Leases 148
Contingent Rentals (contd.)
Contingent rentals are included in income
when they occur.
However, any contingent lease payments
depend only on the passage of time are
included in the MLP.
Accounting for Leases 149
Lease Disclosures
A general description of the leasing
arrangement.
Minimum future payments in the
aggregate and for each of the five
succeeding year (see GRAPHIC 15-16 of the 4th
edition of textbook for example).
Residual values.
Contingent rentals.
Unearned interest.
Sublease rentals.
Executory costs.
Accounting for Leases 150
Sale and Leaseback Arrangements
The owner of an asset sells it and leases it
back from the new owner immediately.
Possible Reasons: 1) to generate cash; 2)
to refinance the asset at a lower interest
rate when the interest rate is declining.
Accounting for Leases 151
Gains and Losses for a Sale-
Leaseback
Gains on the sale of the asset in a sales-
leaseback transaction is deferred and
amortized (i.e., offset with the depreciation
expense of the leased asset in a capital
lease).
A loss on the sale of the asset, however, is
recognized immediately.
Accounting for Leases 152
Sale and Leaseback: Example (capital lease
for lessee)
Clear Water Corp. was in need of cash. To
solve the problem, it sold its two
equipments for $700,000, then lease back
the equipments for its continuous usage.
The equipments had a carrying value on
Clear Water’s books of $520,000 (original
cost $720,000). The sale date is
1/1/2007.Other information:
1. The noncancelable lease term is 10
years and requires the annual payments of
$103,566 beginning 1/1/2007.
Accounting for Leases 153
Sale and Leaseback: example
(contd.)
2. The estimated remaining useful life of the
warehouses is 10 years.
3. The implicit interest of the lessor and the
incremental borrowing rate of the lessee
are 10%.
4. No residual value was expected and a
straight-line depreciation method is used by
Clear Water.
Accounting for Leases 154
Sale and Leaseback: example
(Contd.)-Capital lease for Lessee
1/1/2007 (capital lease for lessee)
Cash 700,000
Acc. Depr. 200,000
Equipment 720,000
Deferred Gain on Sale-leaseback 180,000
Leased Equip. 700,000
Lease Payable 700,000
(PV of MLP= 103,566x6.759)
Lease Payable 103,566
Cash 103,566
Accounting for Leases 155
Sale and Leaseback: example
(contd.)
12/31/07
Interest Expense 59,643
Interest Payable 59,643
Depreciation expense 70,000
Accu. Depreciation 70,000
Deferred Gain 18,000
Depreciation Expense 18,000
Note: if this is an operating lease, the deferred gain
is used to offset the rent expense.
Accounting for Leases 156
Sale and leaseback: example
(contd.)
1/1/08
Interest Payable 59,643
Lease Payable 43,923
Cash 103,566
Accounting for Leases 157
Real Estate Leases
Leases of Land only:
Due to the unlimited life of land, the 75% rule
and 90% test will not apply to land in
determining the lease type.
Therefore, only if criteria a (ownership
transfer) or b (with BPO) is met, a lease of
land will be reported as a capital lease,
otherwise, an operating lease.
Under the capital lease reporting, no
depreciation for land is recognized.
Accounting for Leases 158
Real Estate Leases (condt.)
Lease of Land and Building:
1) Either criterion a or b is met, the lease of
land and building will be recorded separately
and the MLP of the lease would be
allocated between the land and building
based on their separate relative market
values.
2)Neither criterion a nor b is met:
a. the market value of land is equal or less
than 25% of the combined fair value =>
Accounting for Leases 159
Real Estate Leases (condt.)
the lease is treated as a lease of
building only and therefore, both land
and building will be depreciated by the
lessee when it is reported as a capital
lease.
b. the market value of land is more than
25% of combined value: the lease will
be treated as a lease of land and a
lease of building.
. Accounting for Leases 160
Real Estate Lease (contd.)
The classification of the lease type of
the building is similar to the criteria
described earlier and the land is an
operating lease.
Accounting for Leases 161
Leveraged Leases
A third party (i.e., a creditor) provides
financing for a lease agreement between a
lessor and a lessee.
The lessor relies heavily on borrowing to buy
the leased assets.
The liability of the lessor would be offset
against the lease receivable.
Payments from the lessee are applied to the
note payable to the creditor.
Accounting for Leases 162