accounting for leases notes

7/29/2019 Accounting for Leases Notes

1/6

The standard for accounting for leases is found in FASB 13.

Key Definitions in Leasing

The lessoris the one who owns the property (examples: medicalequipment, computer equipment, manufacturing equipment, or real estate)being leased out. The lessor receives the rent. (One easy way toremember which is which: Owner = LessOr!)

The lessee is the one who is using the property and pays the rent. The residual value represents an estimate of what the property being

leased will be worth at the end of the lease term. This is a key concept inleasing and in lease accounting. Reflect on how the residual value willvary depending on whether an asset being leased quickly becomesobsolete (like computer hardware does) or retains much of its value overtime, or even ends up appreciating, such as real estate.

The lessor's implicit interest rate is the rate of return that the lessoruses in computing the rent that it will be charging over the lease term.

The lessee's incremental borrowing rate is the interest rate that thelessee would be required to pay over the lease term if it obtained outsidefinancing of the property being leased.

Accounting Possibilities to the Lessee and to the LessorThe lessee has two accounting possibilities.

1. Underoperating lease accounting, the lessee books neither theequipment leased nor a debt obligation. The lessee just records the rentpaid as rental expense on its income statement. There is one interestingtwist here. The FASB requires the rent expense to be booked over thelease period based upon the benefit derived from the use of the assetbeing leased. In practice, this usually means the same amount of rentexpense being recorded each year over the lease term, even though therent paid is in uneven amounts (usually stepped up) over the lease term.

2. Undercapital lease accounting, at the inception of the lease, the lesseerecords both an asset and a debt (liability) on its balance sheet, just as if ithad purchased the equipment. Thus the balance sheet is grossed up. Onthe lessee's income statement, there is no rental expense; however, theinterest portion of the rental payments is booked as interest expense in

the income statement. The principal portion of the rental payment isrecorded as a reduction of the lease debt on the balance sheet. Further,the equipment is depreciated by the lessee and thus the income statementalso includes a depreciation expense charge. (This is very similar torecording a mortgage payment.)

The lessor has three accounting possibilities.1. Underoperating lease accounting, the lessor (who owns the equipment

being leased out) records rental income for the lease payments received.
http://www.fasb.org/jsp/FASB/Document_C/DocumentPage&cid=1218220124481http://www.fasb.org/jsp/FASB/Document_C/DocumentPage&cid=1218220124481http://www.fasb.org/jsp/FASB/Document_C/DocumentPage&cid=1218220124481


2/6

In addition, the equipment is depreciated, and thus the income statementincludes a depreciation expense charge. Then on the balance sheet, thereis a clear description of assets under operating lease.

2. Underdirect financing lease accounting, at the inception of the lease,the lessor switches the hard asset (equipment) on its books to a soft asset

(a lease receivable or officially called its "net investment in a directfinancing lease"). Its income statement will not show rental income for thislease, but instead will show interest income for the portion of the rentalpayments received that represent interest.

3. Undersales-type lease accounting, at the inception of the lease, thelessor marks up the hard asset (inventory) and records a gross profit forthe excess of sales price over the cost of the inventory. Thus, its incomestatement includes both sales revenue and cost of goods sold expense.Further, just as in the case of direct financing lease accounting, theincome statement will not include rental income but will instead includeinterest income for the portion of the rental payments received that

represent interest. Then on the balance sheet, the lessor would have alease receivable officially called "net investment in sales-type leases."

How to Decide the Proper Lease Accounting

The FASB has issued rules for determining the appropriate accounting forleases.

The FASB's Group I and Group II lease capitalization criteria are both shown indetail below. The lessee needs to focus on only the Group I capitalization criteria;however, the lessor needs to consider both the Group I and the Group II lease

capitalization criteria.The lessee's accounting is straightforwardif the lease meets one or more of theGroup I criteria, then the lessee has a capital lease. On the other hand, if thelessee meets none of the Group I criteria, then it has an operating lease. TheGroup I criteria are evaluated as follows, and only one of them has to be met inorder to record a capital lease.


3/6

For the lessor, treating a lease as capital requires two steps. Once one of theabove Group I criteria has been met, the lessor must meet one of the followingGroup II criteria.Group II

1. It is reasonably predictable as to the collectibility of thepayments required from the lessee.2. There are no important uncertainties surrounding the amountof unreimbursable costs yet to be incurred by the lessor under thelease. The lessor's performance is also substantially complete orfuture costs are reasonably predictable.

To make sure you have mastered whether the lessee has an operating lease or acapital lease, let's try this one.Noncancelable Lease A:

Does not transfer ownership to the lessee Has a purchase option at fair market value Has a lease term of 5 years with the option to lease for another 3 years at

market rental rates The economic life of the equipment being leased is 8 years The minimum lease payments are equal to 90% of the value of the

equipment being leased

Do you think this lease should be capitalized by the lessee?

Well, you have to be very careful about the wording, don't you? Clearly, you don'tmeet Criterion 1. But what about Criteria 2, 3, and 4?You don't meet Criterion 2, because there is no bargain purchase option. OnCriterion 3, you want to include only the noncancelable lease life unless there arebargain lease rental periods (which there are not) and thus the lease life wouldbe 5/8 or 62.5% of the economic life of the equipment being leased. Thus,


4/6

Criterion 3 is not met.

Lastly, Criterion 4 is not met, because the test is on the present value ofminimum lease payments, which have to be lower than the minimum leasepayments, which are only 90% of the fair value of the property being leased.

The end result is that you should have concluded that Lease A is nota capitallease. This exercise is worked through by companies all the time, and there is somuch effort placed in the avoidance of lease capitalization by skirting each of thefour criteria. Most of the time, the focus is on Criterion 4 because it is thetoughest to avoid, because the lessor logically is going to want to get as muchrent as it can. The higher the rent in the lease agreement, the higher the presentvalue of minimum lease payments.

It could well be that the FASB will eventually revisit FAS 13 and its manysubsequent pronouncements on lease accounting. What has happened is thatthe overwhelming majority of leases have been treated as operating leases by

lessee companies by just skirting the lease capitalization rules. (These issues aresome of the primary reasons that the FASB and IASB are working to revise leaserules with the convergence project.)The mental gymnastics for determining the proper accounting by the lessor aremuch more intricate than they are for the lessee. I think a good wayto understand how it works is shown in the following illustration, which addressesevery possible scenario.

Group 1 and 2 Criteria

How Many of theFour Group I

Criteria Are Met?

How Many of theTwo Group II

Criteria Are Met?

Is Asset BeingLeased Marked-

Up?

GAAP AccountingThat Results?

One or more Two No Direct FinancingLease

One or more Two Yes Sales-type Lease

One or more None or one No or Yes Operating Lease

None None, one or two No or Yes Operating Lease

The following example explains the income statement differences to a lessee

between a capital lease and an operating lease. Because the interest expense ishigher in the earlier years than it is in later years, the total expenses under capitallease are higher than under operating lease in the earlier years; this pattern thenreverses in later years. Note that over the entire term of the lease, the totalexpenses reported on the income statement are the same.


5/6

WE-CAN-DO-IT CONSTRUCTION CO.

SCHEDULE OF CHARGES TO OPERATIONS

OPERATING LEASE VS. CAPITAL LEASE

Capital Lease

Year InterestExecutory

Costs DepreciationTotal

ChargesOperating

Lease Difference

2011 7,602.84 2,000.00 20,000.00 29,601.84 25,981.62 (3,620.22)2012 5,963.86 2,000.00 20,000.00 27,963.86 25,981.62 (1,982.24)2013 4,162.08 2,000.00 20,000.00 26,162.08 25,981.62 (180.46)2014 2,180.32 2,000.00 20,000.00 24,180.32 25,981.62 1,801.302015 - 2,000.00 20,000.00 22,000.00 25,981.62 3,981.62

19,908.10 10,000.00 100,000.00 129,908.10 129,908.10 (0.00)

One item that sometimes perplexes learners is the proper handling by the lesseeof executory costs such as property tax and insurance on the asset being leased.The key takeaway here is that you must first determine whether the executorycosts are being passed through to the lessee and are included in the rent beingcharged. If so, then the lessee would back them out of the lease payment todetermine true rent in deriving its lease amortization schedule. On the otherhand, if the lessee pays the executory costs directly to the outside party, thenyou would not reverse the executory costs from the lease payments becausethese lease payments are already true rent. For example, rent is $2,500 per

month with $500 for taxes and insurance. The true rent would be $2,000 permonth. In the above schedule, the executor costs (insurance, taxes, etc.) were inaddition to the lease payment.

Lessor Accounting for Direct Financing Versus Sales-TypeLease

Let's now compare the lessor's accounting for direct financing leases versussales-type leases. The only difference in the accounting template between directfinancing leases and sales-type leases is in the initial entry.

In direct financing leases, the lessor has equipment that gets removed from thebooks and a net investment established (a lease receivable). In sales-typeleases, the lessor has inventory that gets sold. Therefore, in sales-type leases,the inventory is written off, sales revenue is recorded, and the resultant grossprofit is recognized. And just as was the case in the direct financing lease, a netinvestment (or lease receivable) is established for the sales-type lease.

Below are the skeleton lessor entries at the inception of the lease for direct


6/6

financing leases versus sales-type leases.

Direct Financing Lease Sales-Type LeaseDr. Lease Receivable Dr. Lease ReceivableCr. Equipment Dr. Cost of Goods Sold Expense

Cr. Sales RevenueCr. Inventory

Interest revenue on the lease receivable will be higher in the earlier years of thelease than it will be in later years because the lease receivable declines as leasepayments are received (and interest is computed on a decreasing balance).

A lessor using leasing to market its products usually likes to use sales-type leaseaccounting rather than operating lease accounting. The total income recordedwill be the same for all years combined under both methods; however, there willbe much higher earnings in the first year under sales-type lease accounting,

because the gross profit from sales is front ended at the inception of the lease.

IFRS NOTE:

Accounting for leases is defined in IAS 17, which is similar to U.S. GAAP exceptthat "bright-line" criteria are not used. IFRS examines the risks and rewards ofownership. Under U.S. GAAP, the amount initially recorded on a capital lease isthe present value of the minimum lease payments. IAS 17 requires the lesser ofthe fair market value or present value of the minimum lease payments.

accounting for leases notes

Documents