LEASES
Leases–Introduction
A LEASE involves a rental contract. The LESSOR is the owner of the property being leased. The LESSEE uses the leased asset and in return makes lease payments to the lessor.
Companies lease assets because of the advantages, both to the lessee and to the lessor.
The advantages of leasing to a lessee include the following
(1)Reducing (and sometimes completely eliminating) initial down payments. This is
important for companies that do not have sufficient cash or wish to use available
cash for other purposes.
(2)Avoiding the risks of ownership. This may be important for companies in industries
subject to fast technological change, which could render equipment obsolete.
The advantages of leasing to a lessor include these
(1)Increased sales. Many customers who cannot afford to purchase the asset outright
may be able to lease it.
(2)Customer relationship. Leasing keeps the customer in touch, which provides
opportunities to make additional sales.
SFAS No. 13 is the relevant accounting standard for lease accounting.
Operating and Capital Leases
There are two types of leases: operating and capital.
From the perspective of a lessee, the primary difference is the following:
(1)If a lease is classified as an OPERATING LEASE, the rental payments are treated
as periodic expenses in the income statement.
(2)If a lease is classified as a CAPITAL LEASE, the value of the asset and the
related liability are both recorded on the balance sheet (in addition to the periodic interest and depreciation expenses, which are reflected in the income statement). The liability is the future obligation (that is, the required future payments to be made) of the lessee to the lessor.
Lessees would prefer to have leases classified as operating leases. This is so because a capital lease requires the company to record both the leased asset and the related liability. Companies do not like to have the “extra” liability on the balance sheet because it adversely affects financial statement-based ratios (for example, leverage ratios such as debt to equity), which may be used by creditors and investors. Companies also may not like the “extra” leased asset on the balance sheet because it adversely affects other financial ratios that measure performance (for example, return on assets).
Therefore, lessees usually prefer all leases to be classified as operating leases. SFAS No. 13 makes this difficult by imposing four conditions.
These are the four questions:
(1) Will the lessee become the owner of the asset at the end of the lease?
(2) Does the lessee have a bargain purchase option at the end of the lease?
(3) Is the lease term equal to or more than 75 percent of the economic life of the asset?
(4) Is the present value of the minimum lease payments equal to or greater than 90
percent of the fair market value of the asset?
If the answer to all of these four questions is no, both the lessor and lessee will classify the lease as an operating lease.
If the answer to any one of these four questions is yes,
1. The lessee must classify the lease as a capital lease.
2. The lessor must examine two additional conditions (Is the collection of future
payments reasonably certain? Is there no uncertainty about future costs to lessor?). If both of these additional conditions also are met, then it is a capital lease to the lessor; otherwise, it is an operating lease to the lessor.
To recap, to determine whether a lease is a capital lease, four conditions must be examined for the lessee but six conditions must be considered for the lessor.
Accounting for Leases-Definitions
Minimum lease payments include the periodic rental payments, and also any
(a) Guaranteed residual value.
(b) Bargain purchase option price.
(c) Penalties to be paid by lessee for nonrenewal of the lease.
These items are usually specified in the lease contract.
GUARANTEED RESIDUAL VALUE (GUV): Leases sometimes include a guarantee by the lessee that the market value of the asset will not fall below a specified amount, known as the guaranteed residual value. If the market value at the end of the lease term falls below this amount, then the lessee must pay the difference. For example, if the GUV of a leased asset is $10,000 and the actual market value at the end of the lease is only $7,000, the lessee must pay an extra $3,000 at the end of the lease to the lessor.
A BARGAIN PUCHASE OPTION permits the lessee to buy the leased asset at the end of the term by paying an amount significantly less than the expected fair market value of the leased asset at the end of the lease term. When there is a bargain purchase option, the price is set so low that there is a high probability that the lessee will buy the asset (at the end of the lease term).
MINIMUM LEASE PAYMENT do not include any of these:
(a) Contingent payments
(b) Executory costs
(c) Unguaranteed residual value
CONTINGENT PAYMENTS are made only if certain criteria related to the use of the asset are met. For example, the lease may specify, apart from a fixed amount per period, an additional charge for every unit of production or use of the leased asset.
EXECUTORY COSTS are incurred to maintain the leased asset, such as repairs, insurance, and taxes.
IMPLICIT INTEREST RATE is the rate used by the lessor to calculate the desired lease payment. It is the rate of interest that makes the present value of the minimum lease payments equal to the fair market value of the leased asset.
The lessee’s incremental borrowing rate is the rate of interest that the lessee would have had to pay if the lessee had borrowed the lease liability amount from a lender.
The interest rate to be used for discounting in lease calculations is the lower of the implicit interest rate used by the lessor and the incremental borrowing rate of the lessee.
Lessee Accounting-At Acquisition
Before we start discussing lessee accounting for capital leases, let us first take care of operating leases. Accounting for operating leases by the lessee is relatively easy. Each period, there is one journal entry for the lease expense.
If cash is paid, then the journal entry is
DEBIT Lease expense
CREDIT Cash
Accounting for capital leases is much more difficult. When the contract has been signed and the lessee starts using the asset, the lessee treats the transaction as an asset purchased and financed by debt. The journal entry for the transaction is
DEBIT Leased asset
CREDIT Lease liability
What is the amount to be debited and credited? The amount equals the discounted present value of the minimum lease payments specified in the lease.
Assume that Bruce Company leased a machine from Collins Company on 1/1/2002 and that the lease requires payment of $10,000 at the end of each year for four years. Assuming the relevant discount rate to be 10% (we will discuss how to choose the discount rate later), the present value factor of an ordinary annuity for four years discounted at 10% per period equals (from the relevant table) 3.1699. So the total present value of the lease payments is $31,699 ($10,000 3.1699). This will be the amount debited and credited.
Therefore, the journal entry made by Bruce Company on 1/1/2002 will be
DR Leased asset / $31,699CR Lease liability / $31,699
Note: The phrase “obligations under capital lease” means the same thing as “lease liability” and may be used in some textbooks.
Two additional issues need to be discussed: guaranteed residual value and bargain purchase option. If a lease contains either of these two features, the discounted present value of the amount of residual value or bargain purchase option must also be included in the calculations.
For example, in the preceding example, assume that Bruce Company has guaranteed Collins Company that the residual value of the machine at the end of the lease term will be $5,000. The present value factor for four years at 10% is 0.6830. So the present value of the guaranteed residual value is $3,415 ($5,000 x 0.6830). Hence, the debit to the leased asset and the credit to the leased liability will be $35,114 ($31,699 + $3,415).
Lessee Accounting-After Acquisition
Continuing with the Bruce Company example (without any guaranteed residual value), each of the $10,000 payments made at the end of the years has two components. A part of the total payment goes toward interest on the amount owed, and the remainder goes toward reducing the amount owed.
Interest expense for year ended 12/31/2002 = $31,699.00 0.10 = $3,169.90
(Remember: Interest is always calculated based on balance as of the beginning of a period [or the balance as of the end of the previous period]).
The remaining $6,830.10 ($10,000 $3,169.90) is used to reduce the Lease liability account as of 12/31/2002. So, Lease liability as of 12/31/2002 = $31,699.00 $6,830.10 = $24,868.90.
The journal entry related to the payment by the lessee at the end of 2002 is therefore
DR Interest expense / $3,169.90DR Lease liability / 6,830.10
CR Cash / $10,000
Since the leased asset is now on the balance sheet of the lessee, it must be depreciated. Over the term of the lease unless there is a bargain purchase option or the lease becomes the property of the lessee at the end of the lease. If either of these two conditions is present, the economic life of the asset is used for depreciation.
In our example, if the straight-line method is used, the amount of depreciation each year is $7,924.75 (31,699/4). The journal entry for this at the end of 2002 is as follows
DR Depreciation expense-leased asset / $7,924.75CR Accumulated depreciation-leased asset / $7,924.75
This process is repeated every year. We use the following table to show calculations:
Date / Total lease payment (cash) / Interest expense / Reduction of lease liability / Lease liability balance1/1/2002 / $31,699.00
12/31/2002 / $10,000 / $3,169.90 / $ 6,830.10 / 24,868.90
12/31/2003 / 10,000 / 2,486.89 / 7,513.11 / 17,355.79
12/31/2004 / 10,000 / 1,735.58 / 8,264.42 / 9,091.37
12/31/2005 / 10,000 / 908.63 / 9,091.37 / 0
Total / $40,000 / $8,301.00 / $31,699.00
Note:
1. Interest expense as of 12/31/2003 = $24,868.90 0.10 = $2,486.89
2. $7,513.11 ($10,000 $2,486.89) is used to reduce lease liability as of 12/31/2003.
So lease liability as of 12/31/2003 = $24,868.90 $7,513.11 = $17,355.79
3. Similarly calculate for other years. However, for the last year, the interest expense becomes a “plug” number and may differ slightly from calculated interest. This is due to rounding errors.
Thus, for example, journal entries for the year ended 12/31/2004 are
DR Interest expense / $1,735.58DR Lease liability / 8,264.42
CR Cash / $10,000
In addition, there will be the depreciation entry for the year, which is
DR Depreciation expense-leased asset / $7,924.75CR Accumulated depreciation-leased asset / $7,924.75
In this problem, it was assumed that the payments were made at the end of each period. If the payments are made at the beginning of each period, note the following:
1. The first payment (at the beginning of the lease) is used entirely to reduce the lease
liability.
2. At the end of each period, an adjusting entry for interest expense (along with a credit
to interest payable) will be needed; the following day, when the payment is made, the interest payable and lease liability are debited, and cash is credited.
Review Question-1
______is the owner of a leased asset.
______uses a leased asset.
Minimum lease payments include ______.
Minimum lease payments do not include ______.
The leased asset and leased liability must be included on the lessee’s balance sheet if the lease is a(n) ______.
If the lease is classified as a(n) ______, the lessee’s income statement will include a rental expense each period but no interest expense related to the lease.
Answers:
1. Lessor2. Lessee3. Bargain purchase option
4. Executory costs5. Capital lease6. Operating lease
Lessor Accounting-Types of Leases
Accounting by the lessor for an operating lease is relatively easy. The asset remains on the books of the lessor, and each period depreciation is recorded. In addition, rental revenue is recorded each period for the lease payments due from the lessee.
Accounting by the lessor for a capital lease is more difficult. For the lessor, there are two types of capital leases: direct financing and sales type.
A DIRECT FINANCING LEASE is one in which the lessor is a financial institution (for example, a bank or financing company). For the lessor, the lease is an investment and revenue is derived exclusively from the interest component of the lease payments.
A SALES TYPE LEASE is one in which a manufacturer or dealer uses the lease to market an item. In a sales type lease, there are two types of revenue to the lessor: (a) an immediate profit (or loss) at the beginning of the lease and (b) periodic interest revenue (the part of the lease payments that represent the interest).
Lessor Accounting-Direct Financing Lease
We will continue with the example used earlier to illustrate accounting by lessees. Recall that Bruce Company leased a machine from Collins Company and the lease calls for payment of $10,000 at the end of each year for four years. The present value of the lease payments was $31,699.
A payable (liability) for the lessee is a receivable (asset) for the lessor. Interest expense for the lessee is interest revenue for the lessor. Reduction of lease liability for the lessee is reduction of lease receivable for the lessor.
However, there are some differences. The main difference is that the lessor initially records the lease receivable by ignoring the time value of money. So the journal entries for Collins Company, the lessor, are as follows:
At the beginning of the lease (on 1/1/2002):
DR Lease receivable / $40,000CR Equipment inventory / $31,699
CR Unearned interest revenue / $8,301
Note:
1. $40,000 is the total amount of lease payments to be received by the lessor when the time value of money is ignored.
2. Equipment inventory is credited for $31,699 because this is a capital lease, the ownership has transferred from the lessor (to the lessee).
3. The difference between the two amounts represents the total interest expected to be earned over the term of the lease. Since it has not yet been earned, it is unearned revenue (a liability). As interest revenue is earned during the lease period, unearned revenue is reduced each period.
To show journal entries for the subsequent years, we use the same table that we used earlier for lessee accounting with some slight modifications reflecting the fact that we are now discussing accounting by the lessor. The columns now are Cash received as opposed to Cash payment and Interest revenue as opposed to Interest expense. Furthermore, note that we now focus on unearned revenue and its reduction and Lease receivable balance as opposed to Lease liability balance. The Lease receivable balance is reduced each period by the total amount of lease payments.
Date / Total cash received / Interest revenue / Unearned revenue balance / Lease receivable balance1/1/2002 / $8,301.00 / $40,000
12/31/2002 / $10,000 / $3,169.90 / 5,131.10 / 30,000
12/31/2003 / 10,000 / 2,486.89 / 2,644.21 / 20,000
12/31/2004 / 10,000 / 1,735.58 / 908.63 / 10,000
12/31/2005 / 10,000 / 908.63 / 0 / 0
Total / $40,000 / $8,301.00
The table suggests the journal entries each year for the lessor. For example, on 12/31/2003, the journal entries for the lessor are
DR Cash / $10,000CR Lease receivable / $10,000
and
DR Unearned revenue / $2,486.89CR Interest revenue / $2,486.89
The first journal entry is for the receipt of cash and reduction of lease receivable, the second journal entry is for recognizing interest revenue earned on the lease and the corresponding decrease in unearned revenue.
Lessor Accounting-Sales Type Lease
In a sales type lease the fair market value of the leased asset is usually higher than the book value of the leased asset (in the books of the lessor) at the beginning of the lease. This is a capital lease, which is substantially like the sale of an asset. So the difference between market value and book value becomes a profit that the lessor recognizes at the beginning of the lease.
Let us continue with the previous example, in which Bruce Company leased a machine from Collins Company and paid $10,000 at the end of each year for four years. The only difference relates to the book value of the machine at the start of the lease. Assume that the cost of the machine (which Collins Company may have made or bought from someone else) to Collins Company was $25,000. All other facts remain the same as before.
The journal entry by Collins Company is as follows.
DR Lease receivable / $40,000CR Sales revenue / $31,699
CR Unearned interest revenue / $8,301
and
DR Cost of goods sold / $25,000CR Equipment inventory / $25,000
Note:
1. The debit to Lease receivable represents, as before, the fact that the lessor expects to receive $40,000 from the lessee in the future. The credit to Unearned interest revenue arises because we expect to earn that amount as interest revenue in the future. The remainder is sales revenue.
2. The debit to Cost of goods sold and the credit to Equipment inventory are straightforward and represent the fact that ownership of the inventory item has transferred to the lessee.
3. The net effect of these two entries is this: The difference between the credit to Sales revenue and the debit to Cost of goods sold thus is recognized as profit (“manufacturing profit” or “merchandising profit”) in the initial year of the lease. The unearned revenue is recognized as the “financing profit” over the period of the lease.
4. Compare the journal entries for the sales type and direct financing leases. The main difference is the presence of two additional items for the sales type lease-the credit to Sales revenue and the debit to Cost of good sold. Remember, only in a sales type lease can we have Sales revenue and Cost of goods sold.
Sale-Leasebacks, Leveraged Leases, and Real Estate Leases
A SALE-LEASEBACK occurs when the owner of an asset sells the asset to a purchaser but immediately leases it back from the purchaser. Thus, the owner becomes the lessee, and the purchaser becomes the lessor. This is done for financing and/or tax reasons.
In general, lease accounting for the lessor and the lessee in a sale-leaseback is the same as for any other lease. However, there may be a difference between the book value of the asset (on the books of the owner-lessee) and the price for which the asset is sold to the purchaser. Normally, this would be recognized as a gain or profit by the owner lessee. In the case of a sale-leaseback, this difference between book value and sale price is called a “deferred gain” and is recognized throughout the life of the lease.