CHAPTER 21
Accounting for Leases
CHAPTER REVIEW
1. 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
2. (S.O. 1) 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.
*Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.
Advantages of Leasing
3. In discussing the advantages of leasing arrangements, advocates point out that leasing allows for: (a) 100% financing, (b) protection against obsolescence, (c) flexibility, (d) less costly financing, (e) tax advantages, and (f) off-balance sheet financing.
4. A variety of opinions exist regarding the manner in which certain long-term lease arrange-ments 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.
Transfer of Ownership Criteria
5. (S.O. 2) 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:
a. The lease transfers ownership of the property to the lessee at the end of the lease.
b. The lease contains a bargain purchase option.
c. The lease term is equal to 75% or more of the estimated economic life of the leased property.
d. 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.
6. The transfer of ownership criteria is straightforward and easy to apply in practice. 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 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 90% of fair market value test 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
7. Under the capital lease method the lessee treats the lease transaction as if an asset were 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 market 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.
8. 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 guaranteed residual value is the estimated fair (market) value of the leased property at the end of the lease term. This allows the lessor to transfer the risk of loss in the fair value of the asset to the lessee. 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.
9. Executory costs include the cost of insurance, maintenance, and tax expense related to the leased asset. If the lessor makes these payments, such amounts should reduce the present value of the minimum lease payments. When the lease agreement specifies that executory costs are assumed by the lessee, the rental payments can be used without adjustment in the present value computation. 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 to use of the incremental borrowing rate by the lessee in computing the present value of the minimum lease payments. 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.
10. 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.
11. 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.
12. 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 would be included in the entries made for the lease obligation.
Operating Leases for Lessees
13. In accounting for an operating lease, the lessee would use the accounting method known as the operating method. When 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 would make to record operating lease payments includes a debit to Rent Expense and a credit to Cash.
Comparison of Capital Lease with Operating Lease
14. (S.O. 3) 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 would be even larger in the earlier and later years. The following differences occur if a capital lease instead of an operating lease is employed:
a. an increase in the amount of reported debt (both short-term and long-term),
b. an increase in the amount of total assets (specifically long-lived assets), and
c. a lower income early in the life of the lease and, therefore, lower retained earnings.
Special Accounting Problems
19. (S.O. 6) Leases have certain characteristics that create unique accounting problems. The next paragraphs review these characteristics.
Residual Value
20. (S.O. 7) 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.
21. 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 market value of the residual value is less than $8,000, the lessee will have to record
a loss for the difference. For example, if the lessee depreciated the asset down to its residual value of $8,000 but the fair market value of the residual value was $4,000, the lessee would have to record a loss of $4,000. If the fair market 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.
Bargain Purchase Options
23. 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 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.
Disclosure
25. The disclosure requirements for lessors and lessees vary depending upon the type of lease. The required disclosures provide investors with the following information:
a. General description of the nature of the lease,
b. The nature, timing and amount of cash inflows and outflows, including payments to be paid or received for each of the five succeeding years,
c. The amount of lease revenue and expense reported in the income statement each period,
d. Description and amounts of leased assets by major balance sheet classification and related liabilities, and
e. Amounts receivable and unearned revenues under lease agreements.
ILLUSTRATION 21-1
LESSEE’S CAPITALIZATION CRITERIA
ILLUSTRATION 21-2
FLOWCHART FOR LESSEES
ILLUSTRATION 21-3
LESSEE—CAPITAL LEASE
LESSOR—DIRECT FINANCING LEASE
ILLUSTRATION 21-3 (continued)
ILLUSTRATION 21-3 (continued)
ILLUSTRATION 21-5
LESSOR—SALES-TYPE LEASE
LESSEE—CAPITAL LEASE
ILLUSTRATION 21-5 (continued)
ILLUSTRATION 21-6
RESIDUAL VALUE—GUARANTEED
LESSEE—CAPITAL LEASE
LESSOR—DIRECT FINANCING LEASE
ILLUSTRATION 21-6 (continued)
ILLUSTRATION 21-6 (continued)
ILLUSTRATION 21-6 (continued)
ILLUSTRATION 21-7
RESIDUAL VALUE—UNGUARANTEED
LESSEE—CAPITAL LEASE
LESSOR—DIRECT FINANCING LEASE
ILLUSTRATION 21-7 (continued)
ILLUSTRATION 21-7 (continued)
ILLUSTRATION 21-7 (continued)
ILLUSTRATION 21-8
TREATMENT OF SELECTED ITEMS IN
ACCOUNTING FOR LEASES