Leases

ACCOUNTING BY THE LESSOR AND LESSEE

A lease is a contract between a lessor (the owner of the property) and a lessee (the user of the property). Normally the lessee makes periodic payments in exchange for the use of the property. The lease term can be for any period of time that is acceptable to both parties. The periodic payments are called rental payments. The obligation for taxes, insurance and maintenance is specified in the lease contract.

Capital Leases vs. Installment Notes

In the previous chapter we discussed installment notes which are used to purchase equipment and real property. In the example, Spencer Company purchase real estate by paying $50,000 down and arranging a 15-year, 8% mortgage (installment note) for the remaining $200,000. A capitalized lease operates in similar manner.

Example: Spencer Company leases a piece of equipment for five years. The lease meets the criteria for capitalization. The minimum lease payments are $2,107 per month for five years. The following is an amortization schedule for the first calendar year.

Note that the first payment and the origination of the lease are on the same day. Normally a lease requires that the lessee make one or more lease payments on the signing of the lease and transfer of the property. Because this is a capitalized lease instead of an installment purchase the journal entry to record the transaction would be as follows:

The payment made at the signing of the lease would be recorded as follows:

The payment made on May 1, 2003 would be recorded in the same manner as a payment on an installment note.

Conceptual Nature of a Lease

There are a variety of arguments for expensing lease payments as they are made. There are also good arguments for capitalizing leased property as if it were purchased and recording a corresponding debt obligation. The FASB has developed a set of standards that specify if and when a lease transaction must be capitalized. If the lease transfers substantially all of the benefits and risks of ownership of the property the FASB requires that the lease be capitalized.

Capital Leases

Leases are accounted for in one of two ways. If the lease contract is noncancelable and transfers substantially all of the benefits and risks of ownership to the lessee the lease is capitalized. If the lease does not meet these criteria it is accounted for as an operating lease.

In a capitalized lease the lessee records the leased property as an asset and the lease obligation as a liability. The amounts are measured based on the present value of the future rental payments. The lessor records the lease as a sale recording the present value of the future rental payments as the selling price and recognizing the costs of the property in the income statement.

There are very specific criteria that must be met for a lease to qualify as a capital lease. The lease must be noncancelable and meet one or more of the following criteria:

  1. The lease transfers ownership of the property to the lessee
  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

Minimum lease payments include the following:

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

In calculating 90% of the fair value the lessee uses the lesser of:

  1. The lessee’s incremental borrowing rate, or
  2. If known the implicit interest rated computed by the lessor

EXERCISE:

Spencer Company leased equipment from Capital Leasing Company. The lease term is 5 years and requires equal rental payments of $30,000 at the beginning of each year. The equipment has a fair value at the inception of the lease of $138,000, and estimated useful life of 8 years, and no residual value. Spencer Company pays all executory costs directly to third parties. Capital Leasing Company set the annual rental to earn a rate of return of 10%, and this fact is known to Spencer Company. The lease does not transfer title or contain a bargain purchase option. Review the criteria for capitalization and determine if Spencer Company should capitalize this lease. Respond to each of the criteria listed below:

  1. Does the lease transfer ownership of the property to the lessee?

Response:

Solution: No, there is no provision for the transfer of ownership.

  1. Does the lease contain a bargain purchase option?

Response:

Solution: No, there is no bargain purchase option.

  1. Is the term of the lease equal to 75% or more of the economic life of the leased property?

Response:

Solution: No, the term of the lease is not equal to or greater than 75% of the economic life of the property.

  1. Does the present value of the minimum lease payments (excluding executory costs) equal or exceed 90% of the fair value of the leased property?

Response:

Solution: Yes, the present value of the minimum lease payments exceeds 90% of the fair value of the property.

Additional Lessor Conditions for Classification as a Capitalized Lease

From the lessor’s perspective there are two additional conditions that must be met in order for the lessor to classify the lease as a capital lease.

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

Asset and Liability Accounts

If the lease qualifies as a capital lease the lessee records an asset and liability at the lower of:

  1. the present value of the minimum lease payments (excluding executory costs) or
  2. the fair market value of the leased asset at the inception of the lease

Depreciation

Depreciation is recorded on the leased property based on the depreciation policies of the lessee company. If the lease transfers ownership or contains a bargain purchase option the depreciation is allocated over the useful economic life of the leased asset. If the lease does not contain one of these two provisions depreciation is allocated over the term of the lease.

The effective interest method is used to allocate between the interest and principal.

OPERATING LEASES

From the lessee’s perspective

If the above lease did not meet the criteria for capitalization it would be considered an operating lease. Operating leases are recorded as current expenses as the lease obligation is incurred. The following would be the journal entry for the initial lease payment under operating lease accounting.

From the lessor’s perspective

If the lease is classified as an operating lease, the rental payments are record as rental revenue in the periods earned and the underlying property is depreciated in the normal manner based on the lessor’s accounting policies. The leased property and accumulated depreciation are reported separately on the lessor’s balance sheet.

Example: Using the information provided above, if the lease does not qualify as a capitalized lease then Spencer Leasing Company will treat the lease as an operating lease. Under these circumstances the journal entries to record the receipt of rental payments and the annual depreciation on the leased equipment would be recorded as follows.

CAPITALIZED LEASES

From the Lessee’s Perspective

Spencer Company entered into a lease agreement on January 1, 2000, to lease equipment for 10 years. The lease terms require that Spencer Company pay the lessor $25,000 per year including executory costs of $1,000. The first payment is due at the signing of the lease. The useful economic life of the asset is 10 years and there will be no residual value at the end of the lease. Spencer Company can borrow money at the rate of 14% per annum. The lease is designed to give the lessor a 12% return, which is known to the lessee. The first step is to calculate the present value of the future minimum lease payments.

The executory costs are removed to give us the net lease payment. Using Excel we can calculate the present value of the 10 lease payments. Remember this is an annuity due so the first payment does not include any interest. Using a 12% discount rate, which is the lesser of the lessee’s incremental borrowing rate or the implicit interest rate computed by the lessor is know by the lessee, the present value of the minimum lease payments is $151,878. This is the amount that we will capitalize as an asset and liability at the inception of the lease.

The journal entry to capitalize this lease is presented below:

The next step is to prepare a lease amortization schedule so that we will have the appropriate information to record each of the annual payments.


If we assume that the executory costs are for property taxes then the first journal entry to record the signing of the lease and the payment made on January 1, 2000 is as follows.

On December 31, 2000 a journal entry need to be prepared to record the depreciation expense for the first year of use, and the accrued interest on the obligation that will be paid on the first day to the next year. This journal entry is as follows:

On January 1, 2001 we record the actual second payment as follows:

Again, on December 31, 2001 we will need to record depreciation for the second year and accrue the interest associated with the payment that will be made on the following January. The December 31, 2001 journal entry is as follows:

At the end of the lease we will assume that Spencer Company returns the used equipment to the lessor. The journal entry to record this final transaction is as follows:

From the Lessor’s Perspective

Leasing is another form of financing. Many manufactures provide leases for high ticket items in order to stimulate the sale of their products.

Economics of Leasing

In order to lease as opposed to selling products manufacturers must earn a return on the lease above and beyond the profit on the sale of the product. The rate of return that the lessor must earn is called the implicit rate.

CLASSIFICATION OF LEASES BY THE LESSOR

Depending on the circumstances, from the lessor’s perspective a capital lease may be accounted for in one of two ways.

  1. Direct financing lease
  2. Sales-type lease

If at the inception of the lease the lease meets one or more of Group I criteria and both of the Group II criteria the lease will be classified as either a direct financing lease or a sales-type lease. The capitalization criteria for a lessor are as follows:

  • Group I
  • The lease transfers ownership of the property to the lessee
  • The lease contains a bargain purchase option
  • The lease term is equal to 75% or more of the estimated economic life of the leased property
  • 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 unreimbursed costs yet to be incurred by the lessor under the lease

Direct Financing Method

Direct financing leases are those that are arranged through banks or other financial institutions. The lessor is a financing organization and not the manufacturer. The financial institution is providing the resources so that the lessee can acquire the property. The form of financing is a lease as opposed to a debt instrument secured by the property.

There are three pieces of information necessary to record a direct financing lease.

  1. Lease Payments Receivable (Gross Investment)

The minimum lease payments plus the unguaranteed residual value accruing to the lessor at the end of the lease term is recorded as an asset in the general ledger.

The lease payments receivable include:

  1. Rental payments (less executory costs paid by the lessor)
  2. Bargain purchase options, if any
  3. Guaranteed or unguaranteed residual value, if any
  4. Penalty for failure to renew, if any
  1. Unearned Interest Revenue

The fair market value of the property (normally the cost of the item to the lessor) less the lease payments receivable.

  1. Cost of the Inventory of Equipment to the Lessor (Net Investment)

The lessor’s cost of the item is credited to the inventory account at the time the direct financing lease is executed.

Example: Spencer Leasing Company enters into a contract to lease equipment to Alexander Company. The equipment is purchased from Sophie Company for $151,878. Assume that the lease meets the criteria for capitalization. As the lessor Spencer Leasing Company is providing the financing for Alexander Company and therefore this will be accounted for as a direct financing lease. The same facts and circumstances will be used to demonstrate the recording of the lease transactions. The first transaction that must be recorded is the purchase of the equipment by Spencer Leasing Company. The company will purchase and lease (sell) the equipment in simultaneous transactions.


The present value of the minimum lease payments should equal the fair market value at the inception of the lease (the cost to the lessor).

FV of equipment $151,878

To analyze the information that we will need to book this lease transaction and the periodic payment the following amortization schedule is provided.


The lease payments receivable include all payments less executory costs for the duration of the lease. In this example, the lease payments receivable will be $240,000. The unearned interest revenue is the difference between the lease payments receivable and the fair market value of the property at the inception of the lease. In this example, the unearned interest is $88,122 ($240,000 - $151,878).

At the signing of the lease, on January 1, 2000, we will need to book the lease payments receivable, remove the equipment from the lessor’s books and record the unearned interest revenue. The following journal reflects this transaction for this example.

The first lease payment is recorded at the signing of the lease so there is no interest associated with this payment. The following is the journal entry to record the signing of the lease and receipt of the payment on January 1, 2000.

At December 31, 2000 the company will accrue the interest earned on the lease contract as follows:

To record the second payment we will need to record the receipt of the payment. The amortization of unearned interest was already recorded in the above journal entry on December 31, 2000. The journal entry would be recorded as follows:

At December 31, 2001 the company will again accrue the interest earned during the year on the lease contract as follows:

Sales-Type Leases

In a sales-type lease there is a manufacturer’s or dealer’s gross profit or loss.

There are four pieces of information necessary to record a sales-type lease.

  1. Lease Payments Receivable (Gross Investment)

The minimum lease payments plus the unguaranteed residual value accruing to the lessor at the end of the lease termare recorded as an asset at the inception of the lease.

  1. Unearned Interest Revenue

The gross investment less the fair market value of the asset.

  1. Sales Price of the Asset

The present value of the minimum lease payments.

  1. Cost of Goods Sold

The cost of the asset to the lessor, less the present value of any unguaranteed residual value.

Example: Spencer Manufacturing Company sells and leases equipment to pet supply distributors. Assume the same facts and circumstances as in the above two examples except that it cost Spencer Manufacturing Company $110,000 to manufacture the equipment that is going to be leased to Alexander Company. We will assume that Alexander Company has guaranteed a residual value at the end of the lease is $5,000.

Under this scenario the selling price of the equipment has changed. The following provides a calculation of the selling price of the equipment.

With the guaranteed residual the net present value of the entire package is now $153,488. We can now calculate the rest of the components of the sale-type lease agreement. The following provides this analysis.

The gross investment includes the ten annual payments and the guaranteed residual.

The unearned interest revenue is equal to the gross investment less the present value of the minimum lease payments and the present value of the guaranteed residual.

The sales price is the present value of the minimum lease payments plus the present value of the guaranteed residual.

The cost of goods sold was given in the question.

The gross profit is the sales price less the cost of goods sold.

To better visualize the transactions in this sales-type of lease the following is an amortization schedule prepared for Spencer Leasing Company.

With the above computations complete we can now prepare the journal entries to record the lease transactions. The first journal entry is to record the sales-type lease at inception.

Along with the signing of the lease the lessee makes the first payment. The following journal records the receipt of the first lease payment.