Lease Accounting (New FASB Rules) | Intermediate Accounting | CPA Exam FAR | Chapter 21

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This page covers accounting for leases for the lessor and lessee, including capital leases, operating leases and sales leaseback.

Financial Accounting and Reporting (FAR) section of the CPA exam

Intro to Accounting for Operating Leases

Operating Lease Accounting--Lessee & Lessor

Accounting for Leases: Bargain Purchase Option/Lease Prepayment

Residual Value for Leases--Guaranteed & Not Guaranteed

Accounting for Leases: Sales-Leaseback

Accounting for Finance Lease: Lessor's Perspective (Carmichael)

Accounting for Finance Lease: Lessee's Perspective (Banket)

Accounting for Finance Lease: Lessee's Perspective (Sterling)

Accounting for Finance Lease: Lessor's Perspective (Caterpillar)

Example: Accounting for Operating Leases--Lessee and Lessor

Lease Classification | Practice Questions CPA Exam FAR

Lessee Accounting: Initial Measurement | Practice Questions CPA Exam FAR

Lessee Accounting: Subsequent Measurement (1 of 2) | Practice Questions CPA Exam FAR

Lessee Accounting: Subsequent Measurement (2 of 2) | Practice Questions CPA Exam FAR

Lessor Accounting for Sales-Type Leases (1 of 2)| Practice Questions CPA Exam FAR

This page covers accounting for leases for the lessor and lessee including capital leases, operating leases and sales lease-back.

Many businesses lease substantial portions of the property and equipment they use in their business organization as an alternative to ownership. Because leasing provides some financial, operating, and risk advantages over ownership, it has become the fastest growing form of capital investment. This increased significance of lease arrangements in recent years has intensified the need for uniform accounting and complete informative reporting of leasing transactions. Chapter 21 presents a discussion of the accounting issues related to leasing arrangements from the point of view of both the lessee and the lessor. Among the issues discussed are: (1) the classification of leasing arrangements, (2) the various methods used in accounting for leases, and (3) the financial statement disclosure requirements when leases are present.

The Leasing Environment

A lease is a contractual agreement between a lessor and a lessee that gives the lessee the right to use specific property, owned by the lessor, for a specified period of time. In return for this right, the lessee agrees to make rental payments over the lease term to the lessor.

The lessors that own property include banks, captive leasing companies, and independents.

Advantages of Leasing

In discussing the advantages of leasing arrangements, advocates point out that leasing allows for: (a) 100% financing at fixed rates, (b) protection against obsolescence, (c) flexibility, (d) less costly financing, (e) tax advantages, and (f) off-balance-sheet financing.

A variety of opinions exist regarding the manner in which certain long-term lease arrange­ments should be accounted for. These opinions range from total capitalization of all long-term leases to the belief that leases represent executory contracts that should not be capitalized. The FASB requires capitalization of lease arrangements that are similar to installment purchases. In short, lease arrangements that transfer substantially all of the risks and rewards of ownership of property should be capitalized by the lessee.

Lessee Accounting – Capitalization Criteria

For accounting purposes of the lessee, all leases may be classified as operating leases or capital leases. For a lease to be recorded as a capital lease, the lease must be noncancelable and meet one of the following four criteria:

  1. The lease transfers ownership of the property to the lessee at the end of the lease.
  2. The lease contains a bargain-purchase option.
  3. The lease term is equal to 75% or more of the estimated economic life of the leased property.
  4. The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90% of the fair value of the leased property.

If the lease meets none of the four criteria, the lease should be classified and accounted for as an operating lease.

A bargain purchase option is a provision allowing the lessee to purchase the leased property for a price that is significantly lower than the property’s expected fair value at the date the purchase option becomes exercisable. The 75% of economic life test is based on the belief that when a lease period equals or exceeds 75% of the asset’s economic life, the risks and rewards of ownership are transferred to the lessee and capitalization is appropriate. The reason for the recovery of investment test (90%) is that if the present value of the minimum lease payments are reasonably close to the market price of the asset, the asset is effectively being purchased. A major exception to the 75% and 90% rules is when the inception of the lease occurs during the last 25% of the asset’s life. When this occurs the 75% and 90% tests should not be used.

Capital Leases for Lessees

Under the capital lease method, the lessee treats the lease transaction as if an asset is being purchased over time (installment basis). For a capital lease, the lessee records an asset and a liability at the lower of (a) the present value of the minimum lease payments during the term of the lease or (b) the fair value of the leased asset at the inception of the lease. In determining the present value of the minimum lease payments, three important concepts are involved: (a) minimum lease payments, (b) executory costs, and (c) the discount rate.

Minimum lease payments include (a) minimum rental payments, (b) any guaranteed residual value, (c) penalty for failure to renew or extend the lease, and (d) any bargain- purchase option. Minimum rental payments are the minimum payments the lessee is obligated to make to the lessor under the lease agreement. A residual value is the estimated fair value of the leased property at the end of the lease term. The guaranteed residual value is (a) the certain or determinable amount at which the lessor has the right to require the lessee to purchase the asset, or (b) the amount the lessee or the third-party guarantor guarantees the lessor will realize. This allows the lessor to transfer the risk of loss in the fair value of the asset to the lessee.

If the lessee guarantees the residual value, the present value of this residual value should be reported as part of the lease liability. If a bargain purchase option exists instead of a guaranteed residual value, the lessee should increase the present value of the minimum lease payments by the present value of the option price. In both the guaranteed residual value and the bargain purchase option cases, the lessee is committed to making these payments, and therefore the payments should be reported as an increase to the lease liability.

Executory costs include the cost of insurance, maintenance, and tax expense related to the leased asset. If the lessor makes these payments, such amounts are not included in the present value of the minimum lease payments.

The lessee uses its incremental borrowing rate (discount rate) to compute the present value of the minimum lease payments. This rate, often determined by the exercise of professional judgment, is defined as the rate that, at the inception of the lease, the lessee would have incurred to borrow the funds necessary to buy the leased asset. There is one exception: If the lessee knows the implicit rate computed by the lessor, and that rate is less than the lessee’s incremental borrowing rate, then the lessee must use the implicit rate.

When the lessee uses the capital lease method, each lease payment is allocated between a reduction of the lease obligation and interest expense applying the effective-interest method. The lessee should amortize the leased asset by applying one of the conventional depreciation methods. During the term of the lease, assets recorded under capital leases are separately identified in the lessee’s balance sheet. Likewise, the related obligations are separately identified with the portion due within one year or the operating cycle, whichever is longer, classified with current liabilities and the balance with noncurrent liabilities.

A complete illustration of the accounting for a capital lease by the lessee is found in the text. It is important to understand the preparation of the Lease Amortization Schedule. This schedule provides the basis for the entire range of journal entries for the lease transaction. The basic entries include: (a) initial capitalization which requires a debit to the asset and a credit to the liability, (b) annual lease payments which include a debit to the liability and a credit to cash, and (c) the annual depreciation entry. Of course, any interest accrual or executory costs will also be recorded in connection with the lease obligation.

Asset and Liability Accounted for Differently

The rental payments to the lessor constitute a payment of principal plus interest. The lessee records a capital lease as an asset and a liability at the lower of (1) the present value of the minimum lease payments (excluding executory costs) or (2) the fair value of the leased asset at the inception of the lease.

If the lease agreement transfers ownership of the asset or contains a bargain purchase option, the leased asset is depreciated over its economic life. If the lease agreement has no bargain purchase option or does not transfer ownership, it is depreciated over the lease term.

When applying the effective-interest method to capital leases, the lessee uses the same discount rate that was used to determine the present value of the minimum lease payments.

When applying the effective-interest method to capital leases, the lessee must use the same discount rate that determines the present value of the minimum lease payments.

Operating Leases for Lessee

In accounting for an operating lease, the lessee uses the operating method. The periodic rent associated with the lease is recognized in the period benefited by the leased asset. Under this method, the commitment to make future rental payments is not recognized in the accounts. Only footnote recognition is given to the commitment to pay future rentals. The journal entry the lessee includes a debit to Rent Expense and a credit to Cash.

Comparison of a Capital Lease with an Operating Lease

While the total charges to operations are the same over the lease term whether the lease is accounted for as a capital lease or as an operating lease, under the capital lease treatment, the charges are higher in the earlier years and lower in the later years. If an accelerated method of depreciation is used, the differences between the amounts charged to operations under the two methods is even larger in the earlier and later years. The following differences occur if a lease is accounted for as a capital lease instead of an operating lease:

  1. An increase in the amount of reported debt (both short-term and long-term),
  2. An increase in the amount of total assets (specifically long-lived assets), and
  3. A lower income early in the life of the lease and, therefore, lower retained earnings.

Accounting by Lessors

Three benefits available to the lessor are (a) competitive interest margins, (b) tax incentives, and (c) high residual values.

For lessor accounting purposes, all leases may be classified as: (a) operating leases, (b) direct-financing leases, or (c) sales-type leases. The lessor should classify and account for an arrangement as a direct financing lease or a sales-type lease if at the date of the lease agreement one or more of the following Group I criteria are met and both of the following Group II criteria are met.

Group I

  1. The lease transfers ownership of the property to the lessee at the end of the lease.
  2. The lease contains a bargain-purchase option.
  3. The lease term is equal to 75% or more of the estimated economic life of the leased property.
  4. The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90% of the fair value of the leased property.

Group II

  1. Collectibility of the payments required from the lessee is reasonably predictable.
  2. No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease.

The distinction between a direct-financing lease and a sales-type lease is that a sales-type lease involves manufacturer’s or dealer’s profit (or loss) and a direct financing lease does not. The primary difference between applying the financing method to a direct-financing lease and applying it to a sales-type lease is the recognition of the manufacturer’s or dealer’s profit at the inception of the lease. The profit or loss to the lessor is evidenced by the difference between the fair value of the leased property at the inception of the lease and the lessor’s cost or carrying amount (book value). All leases that do not qualify as direct-financing or sales-type leases are classified and accounted for by lessors as operating leases.

A lessor should account for an operating lease using the operating method. Under the operating method, each rental receipt of the lessor is recorded as rent revenue on the use of an item carried as a depreciable asset. The asset is depreciated in the normal manner, with the depreciation expense of the period being matched against the rental revenue.

Direct Financing Method (Lessor)Leases that are in substance the financing of an asset purchase by the lessee are called direct-financing leases. The lessee debits a lease receivable and credits the leased asset account for the present value of the minimum lease payments. “Minimum lease payments” includes:

  1. Rental payments (excluding executory costs),
  2. Bargain-purchase option (if any),
  3. Guaranteed residual value (if any), and
  4. Penalty for failure to renew (if any).

Special Lease Accounting Problems

Leases have certain characteristics that create unique accounting problems, including residual values, sales-type leases, bargain-purchase options, initial direct costs, current versus noncurrent classification, and disclosure.

Residual Value

The residual value of a leased asset is the estimated fair value of the asset at the end of the lease term. The residual value may be guaranteed or unguaranteed by the lessee. A guaranteed residual value is said to exist when the lessee agrees to make up any deficiency below a stated amount in the value of the asset at the end of the lease term.
A guaranteed residual value affects the lessee’s computation of the minimum lease payments and, therefore, the amounts capitalized as a leased asset and a lease obligation. The lessor assumes the residual value will be realized at the end of the lease term whether guaranteed or unguaranteed.

To understand the accounting implications of a guaranteed residual value, assume a lessee guarantees the residual value of an asset will be $8,000. If, at the end of the lease, the fair value of the residual value is less than $8,000, the lessee will have to record
a loss and make a payment for the difference. If the lessee depreciated the asset down to its residual value of $8,000, but the fair value of the residual value was $5,000, the lessee would have to record a loss of $3,000. If the fair value of the asset exceeds the $8,000, a gain may be recognized. Gains on guaranteed residual values may be apportioned to the lessor and lessee in whatever ratio the parties initially agree.

Sales-Type Leases

In a sales-type lease, the lessor records the sales price of the asset, the cost of goods sold and related inventory reduction, and the lease receivable.

Under sales-type leases, the profit recorded by the lessor at the point of sale is the same whether the residual value is guaranteed or unguaranteed, but the sales revenue and cost of goods sold amounts are different. The present value of the unguaranteed residual value is deducted from sales revenue and cost of goods sold.

Bargain-Purchase Option

A bargain-purchase option is a provision allowing the lessee, at his or her option, to purchase the leased property at a price that is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable. When a bargain-purchase option exists, the lessee must increase the present value of the minimum lease payments by the present value of the purchase option price. The only difference between accounting for a bargain-purchase option and a guaranteed residual value of identical amounts is in the computation of the annual depreciation. In the case of a guaranteed residual value, the lessee depreciates the asset over the lease life. When a bargain-purchase option is present, the lessee uses the economic life of the asset in computing depreciation.

Initial Direct Costs

Initial direct costs are the costs incurred by the lessor that are directly associated with negotiating and consummating a completed leasing transaction. There are two types of initial direct costs, incremental direct costs and internal direct costs. Incremental direct costs are costs incurred in originating a lease arrangement that are paid to third parties. Internal direct costs are costs directly related to specified activities performed by the lessor on a given lease. When an operating lease is present, the initial direct costs are deferred and amortized over the life of the lease in proportion to rental income. In a sales-type lease, these costs are expensed in the period that profit on the sale is recognized. For direct-financing leases, initial direct costs are added to the net investment in the lease and amortized over the life of the lease as a yield adjustment.

Lease Disclosure Requirements

The disclosure requirements for lessors and lessees vary depending upon the type of lease. The required disclosures provide investors with the following information:

  1. General description of the nature of leasing arrangements.
  2. The nature, timing, and amount of cash inflows and outflows associated with leases, including payments to be paid or received for each of the five succeeding years.
  3. The amount of lease revenue and expenses reported in the income statement each period.
  4. Description and amounts of leased assets by major balance sheet classification and related liabilities.
  5. Amounts receivable and unearned revenues under lease agreements.

In practice, the strong desires of lessees to resist capitalization have rendered the accounting rules for capitalizing partially ineffective. The lessee’s use of the higher interest rate is probably the more popular subterfuge. The residual value guarantee if the other unique, yet popular, device used by lessees and lessors.

Sale-Leaseback

A “sale-leaseback” transaction is one in which the owner of property sells it to another and simultaneously leases it back from the new owner. The seller-lessee, in a sale-leaseback transaction, should apply the same criteria mentioned earlier in deciding whether to account for the lease as a capital lease or an operating lease. Likewise, the purchaser-lessor should apply the criteria mentioned earlier in deciding whether the sale-leaseback transaction should be accounted for using the operating method or the financing method.