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Acct 414 – Spring 2009 Prof. Teresa Gordon
FASB 13 (as amended) - ACCOUNTING FOR LEASES
(IFRS notes are at the end)
Synopsis:
A lease that transfers substantially all of the benefits and risks of ownership should be accounted
for as the acquisition of an asset and the incurrence of an obligation by the lessee and as a sale or
financing by the lessor.
US GAAP - CRITERIA FOR CAPITALIZATION:
FOR LESSEE AND LESSOR: (must meet at least one)
A1 - TITLE TRANSFERS. The lease transfers ownership of the property to the lessee by the
end of the lease term.
A2 - BARGAIN PURCHASE OPTION. The lease contains an option to purchase the leased
property at a bargain price.
A3 – ECONOMIC LIFE. The lease term is equal to or greater than 75% of the estimated
economic life of the leased property.
A4 – RECOVERY OF INVESTMENT. The present value of the minimum lease payments
equals or exceeds 90% of the fair value of the leased property less any investment tax credit
retained by the lessor.
FOR LESSOR ONLY: (must meet both)
B1 - COLLECTIBILITY. Collectibility of the minimum lease payments is reasonably
predictable.
B2 - NO UNCERTAINTIES. No important uncertainties surround the amount of
unreimburseable costs yet to be incurred by the lessor under the lease.
EXCEPTIONS:
USED PROPERTY: If lease term falls within the last 25% of the useful
economic life of property, use only criteria A1 and A2 (plus B1 and B2 for
lessor).
REAL ESTATE:
Use criteria A1 and A2 only for leases of land (plus B1 and B2 for lessor).
If land value is 25% or more of value of leased land and buildings, separate land
and building and apply criteria separately. Otherwise, ignore land and treat as
building only.
Sales-type lease of real estate possible only if criteria A1 (title transfer) is met.
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Acct 414 – Spring 2009 Prof. Teresa Gordon
LEASE CLASSIFICATION
FOR LESSEE
Capital Lease - lease that meets any one of the first four criteria (A1 to A4).
Operating Lease - lease that does not meet any of the first four criteria (A1 to A4)
FOR LESSOR:
Sales-type lease - lease that meets any one of the first four criteria (A1 to A4) and both of the
second criteria (B1 and B2) and gives rise to manufacturer's or dealer's profit or loss.
EXCEPTION: If real estate is included in lease, it is sales-type lease only if title
transfers (criteria A1 or A2). Otherwise, classify as operating.
Direct financing lease - lease that meets any one of the first four criteria (A1 to A4) and both of
the second criteria (B1 and B2) and does not give rise to manufacturer's or dealer's profit or loss
(and it does not meet criteria for leveraged lease).
Leveraged lease
In a leveraged lease, a third party provides nonrecourse financing to the lessor to fund the leasing
arrangement.
The lessor then makes periodic payments to the third party lender to satisfy its debt obligation.
Technically, a leveraged lease is a direct financing lease that has all of the following
characteristics:
1. Involves three parties: lessee, long-term creditor and a lessor (equity participant).
2. Financing provided is nonrecourse to the lessor and is sufficient to provide substantial
leverage in the transaction.
3. Lessor's net investment declines during early years and rises during later years of lease.
Operating lease - lease that fails to meet all of the first four criteria (A1 to A4) or one that fails
to satisfy one or both of the second set of criteria (B1 and B2).
INTEREST RATES FOR PRESENT VALUE COMPUTATIONS:
LESSOR - uses interest rate implicit in the lease
LESSEE - uses lower of lessee's incremental borrowing rate or lessor's implicit interest rate
Comment - Why the lower of the two rates?
To avoid the understatement of a liability by the lessee (if their rate is too high).
The lessor’s rate is usually more reasonable (lower).
Lessee cannot use too low a rate because, by conservatism, an asset cost
cannot be > the FMV.
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Acct 414 – Spring 2009 Prof. Teresa Gordon
COMMENTS ON APPLYING CRITERIA
LEASE TERM:
Always ends at a bargain purchase option (including ordinary renewal periods up to
BPO).
Includes renewal periods
under bargain renewal options
if there is a penalty large enough to assure renewal
if renewal or extensions is at option of lessor
during which lessee guarantees lessor's debt related to property
during which there is a loan from lessee to the lessor
Lease must be cancelable only under remote contingency, with permission of lessor, or if
lessee enters into new lease with lessor, or with there is a large penalty for cancellation
that makes cancellation unlikely.
MINIMUM LEASE PAYMENTS:
Excludes contingent rentals
Excludes executory costs paid by lessor:
maintenance
property taxes
insurance
Excludes all rental payments past date of bargain purchase option
Includes all rental payments up to date of bargain purchase option
Includes bargain purchase option
Includes renewal penalties not large enough to assure continuation of lease
Includes rents during renewal periods covered by:
bargain renewal options
nonrenewal penalty large enough to assure continuation of lease
Includes guaranteed residual value of property -
If guaranteed by lessee
If guaranteed by third party, only lessor includes as part of minimum lease
payments
Note:
Never record the leased asset at more than its fair value!
The asset should be recorded at the lower of the PVMLP or the FMV.
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ACCOUNTING FOR LEASES
LESSEE - Capital Leases:
Record asset and liability in amount equal to present value of minimum lease
payments (not to exceed fair value of property).
Record depreciation expense: If title transfers or there is a bargain purchase
option, use property's economic life. Otherwise, depreciate over the lease term.
Record lease payments interest expense and reduction of liability using effective
interest method of amortization.
LESSEE - Operating Leases:
Charge rent to expense over lease term as it becomes payable.
Note: If rental payments are not made on a straight-line basis, rental expense
nevertheless shall be recognized on a straight-line basis
LESSOR - Sales-type Lease:
Record gross investment in lease as asset:
minimum lease payments (excluding executory costs)
unguaranteed residual value
Record contra-asset account for unearned income:
difference between gross investment in lease and present value of gross
investment in lease
Record revenue in amount of present value of minimum lease payments.
Record expense for:
cost or carrying amount of property plus
any initial direct costs less
the present value of the unguaranteed residual value.
Record interest revenue over lease term using effective interest method
Review residual values annually and record loss if necessary.
LESSOR - Direct Financing Lease:
Record gross investment in lease as asset:
minimum lease payments
unguaranteed residual value
initial direct costs
Record contra-asset account for unearned income:
difference between gross investment in lease and present value of gross
investment in lease
Record interest revenue over lease term using effective interest method
Review unguaranteed residual values annually and record loss as necessary
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LESSOR - Operating Lease
Include leased property with property, plant and equipment
Depreciate property using usual methods
Record rental revenue as it becomes receivable according to lease terms.
Note: If rental payments are not made on a straight-line basis, rental revenue
nevertheless shall be recognized on a straight-line basis.
Initial direct costs are deferred and amortized over lease term in proportion to recognition
of rental revenue.
Initial Direct Costs
COMMENT: Notice different handling of initial direct costs: They are expensed for
sales-type leases. They are capitalized as part of gross investment in lease for direct
financing leases which means they reduce interest revenue over the lease term. They are
capitalized and amortized over lease term for operating leases.
LESSOR - Leveraged Lease
Record gross investment in lease as an asset net of nonrecourse debt:
Rentals receivable from lessee, net of principal and interest payments to long-term
creditor
Receivable for the amount of ITC to be realized
Estimated Residual value of leased asset
The unearned and deferred revenue (derived by creating a cash flow analysis by
year for lease term so that income is recognized only in years with a positive cash
flow.
Record contra-asset account for unearned and deferred revenue
(gross lease rentals - depreciation - loan interest) + unamortized ITC
Interest revenue is recorded only in years with positive cash flow
Record deferred taxes for temporary difference between accounting and taxable income
figures
Payments to long-term creditor are debited to gross investment in lease
Payments from lessee are credited to gross investment in lease
Review unguaranteed residual values annually and record loss as necessary
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JOURNAL ENTRY FORMAT FOR LESSOR LEASE
CAPITALIZATION:
(As illustrated by FASB -- use of Gross rather than Net investment in lease is optional.
Net investment in lease = GIIL - unearned income)
DIRECT FINANCING LEASE:
Gross Investment in Lease (MLP + Unguaranteed Residual Value + initial direct costs)
Equipment (Cost or carrying amount)
Unearned Income (GIIL - cost or carrying amount)
SALES TYPE LEASE:
Gross Investment in Lease (MLP + Unguaranteed Residual Value)
Cost of Sales (Cost of asset - PV of Unguaranteed Residual Value)
Inventory/Equipment (Cost of asset)
Unearned Income (GIIL -PVMLP)
Sales Revenue (PVMLP)
Where MLP = minimum lease payments exclusive of executory costs paid by the lessor
GIIL = gross investment in lease
PVMLP = present value of MLP
The “easier” method:
DIRECT FINANCING LEASE:
Net Investment in Lease (PVMLP + PV of Unguaranteed Residual Value + initial direct costs)
Equipment (Cost or carrying amount)
SALES TYPE LEASE:
Net Investment in Lease (PVMLP + PV of Unguaranteed Residual Value)
Cost of Sales (Cost of asset - PV of Unguaranteed Residual Value)
Inventory/Equipment (Cost of asset)
Sales Revenue (PVMLP)
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Depreciation Period
If lease criteria A-1 (TT) or A-2 (BPO) is met, use lessee’s normal
economic life of the asset (since the lessee will continue to
have use of the asset after the end of the lease term).
If neither criteria A-1 or A-2 is met, amortize over the term of the lease
(ownership is not transferred)
Recognize Interest Expense and Revenue:
Use the effective interest method to allocate each payment to
principal and interest using the discount rate.
For lessee - use same rate you used to compute the PVMLP
Lessor will use interest rate implicit in the lease
LEASE DISCLOSURES
LESSEE:
1. General description of leasing arrangement including
a. Basis of computing contingent payments
b. Existence and terms of renewal or purchase options and escalation clauses
c. Restrictions imposed by lease agreements
2. Capital leases
a. Classify liability as current/noncurrent
b. Separate depreciation disclosure
c. Future minimum lease payments in aggregate and for each of next 5 years showing executory
costs and imputed interest
d. Total minimum sublease rentals to be received
e. Total contingent rental actually incurred for each period presented
3. Operating lease - noncancelable term in excess of 1 year
a. Future minimum lease payments in aggregate and for each of next 5 years
b. Total minimum sublease rentals to be received in future
4. All operating leases
a. Separate amounts for minimum rentals, contingent rentals and sublease rentals
b. Rental payments for leases with a term of a month or less may be excluded
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LESSOR (WHEN LEASING IS A PREDOMINANT ACTIVITY)
1. General description of leasing arrangements
2. Sales-type and direct financing lease disclosure
a. Components of net investment in leases
Future minimum lease payments with separate deductions for executory costs and allowance for
bad debts
Unguaranteed residual values
Initial direct costs for direct financing only
Unearned income
b. Future minimum lease payments for each of next 5 years
c.Contingent rentals earned each period presented
3. Operating lease disclosures
a.Cost of property in total and by major property category and total accumulated depreciation
b. Minimum noncancelable rentals in aggregate and for each of next 5 years
c.Total contingent rentals for each income statement presented
ACCOUNTING FOR SALE AND LEASEBACK
TRANSACTIONS (GENERAL)
Owner of property sells property to lessor who leases it back to the original owner.
SELLER-LESSEE
Use normal rules to classify as operating or capital lease.
Assuming seller-lessee retains use of property after transaction, defer any profit or loss and
amortize in proportion to the amortization of the leased property (capital lease) or in proportion
to gross rental charged (operating lease).
If seller-lessee leases back only small part of property, account for each transaction
separately.
If seller retains more than a minor part but less than substantially all of the property --
recognize gain to extent gain exceeds PV of lease payments (operating lease), or recorded
amount of leased asset (capital lease) at date of sale.
BUYER-LESSOR:
If lease meets at least one of criteria A1 to A4, and both B1 and B2, record the transaction as a
direct financing lease. Otherwise, it is an operating lease.
WARNING:
EXCEPTIONS IF REAL ESTATE IS INVOLVED -- SEE FASB 98
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FASB 98 - Sale and Leaseback Transactions Involving
Real Estate
Must qualify as a sale under provisions of FASB 66 Accounting for Sales of Real Estate.
Sale/Leaseback accounting would be used only in the following circumstances:
1. Seller-lessee intends to occupy property from the inception of the lease
2. Payment terms and provisions adequately demonstrate the buyer-lessor's initial
and continuing investment in the property
3. Provisions of agreement transfer all the risks and rewards of ownership (other
than normal leaseback) -- demonstrated by absence of any continuing
involvement by seller-lessee
CONTINUING INVOLVEMENT -- TYPICAL EXAMPLES:
a. Seller-lessee is obligated to repurchase the property or buyer-lessor gives
seller-lessee an option to repurchase the property
b. Seller-lessee guarantees the buyer-lessor's investment
c. Seller-lesee is required to pay the buyer-lessor for a decline in fair value of
property below estimated residual value
d. Seller-lessee provides nonrecourse financing to buyer-lessor for any
portion of sales proceeds
e. Seller-lessee is not relieved of obligation under existing debt related to
property
f. Seller-lessee sells improvements or equipment to buyer-lessor and leases
them back while retaining the underlying land
A sale that does not qualify for sales recognition because of any form of continuing involvement
would be accounted for under the deposit method or as a financing transaction.
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International Financial Reporting Standards (IFRS)
Leases (IAS17)
A lease is classified as a finance lease if it transfers substantially all the risks and rewards
incidental to ownership. A lease is classified as an operating lease if it does not transfer
substantially all the risks and rewards incidental to ownership.
Classification depends on the substance of the transaction rather than the form of the contract.
Examples of situations that individually or in combination would normally lead to a lease being
classified as a finance lease are:
a) the lease transfers ownership of the asset to the lessee by the end of the lease term.
b) the lessee has the option to purchase the asset at a price that is expected to be sufficiently
lower than the fair value at the date the option becomes exercisable for it to be
reasonably certain, at the inception of the lease, that the option will be exercised.
c) the lease term is for the major part of the economic life of the asset even if title is not
transferred.
d) at the inception of the lease the present value of the minimum lease payments amounts to
at least substantially all of the fair value of the leased asset.
e) the leased assets are of such a specialized nature that only the lessee can use them
without major modifications.
Other indications that it is a finance lease include:
a) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are
borne by the lessee.
b) gains or losses from the fluctuation in the fair value of the residual accrue to the lessee
(for example, in the form of a rent rebate equalling most of the sales proceeds at the end
of the lease)
c) the lessee has the ability to continue the lease for a secondary period at a rent that is
substantially lower than market rent.
The examples and indicators (above) are not always conclusive. If it is clear from other features
that the lease does not transfer substantially all risks and rewards incidental to ownership, the
lease is classified as an operating lease.
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Differences in terminology
IFRS US GAAP
For Lessor Operating lease Operating lease
Finance lease Direct Financing Lease
Finance lease Sales-type lease
Finance lease Leveraged lease
For Lessee Operating lease Operating lease
Finance lease Capital lease
INITIAL DIRECT COSTS
Type of Lease Accounting Treatment for Initial Direct Costs
Operating Recorded as an asset and amortized over the lease term*
Direct Financing (US) Recorded as part of investment in lease and amortized over
lease term by reducing interest revenue (find new
Finance (IFRS) implicit rate)*
Sales-type Lease (US) Immediately recognized as cost of goods sold (reduces profit
or increases loss on sale of leased asset)
Finance if lessor is
manufacturer or
dealer (IFRS)
What interest rate to use:
IFRS US GAAP
“The discount rate to be used in Lessors always use the interest rate
calculating the present value of the implicit in the lease
minimum lease payments is the The lessee uses the LOWER of the
interest rate implicit in the lease, if this implicit interest rate and their own
is practicable to determine; if not, the incremental borrowing rate
lessee’s incremental borrowing rate
shall be used.
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