Lease Accounting

Leases
Sid Glandon, DBA, CPA

Associate Professor of Accounting
University of Texas at El Paso
1
Basics of Leasing
Lease
Contractual agreement between lessor and

lessee
Gives lessee right to use specific property
Specifies duration and rental payments
Executory costs
Taxes, insurance and maintenance
May be assumed by either party
2
Advantages
100%
financing at fixed rates

Protection against obsolescence
Flexibility
Less costly financing
AMT problems avoided
Off-balance-sheet financing
3
Classification of Leases
Capital
leases
If lease transfers substantially all of the

benefits and risks of ownership
Must be noncancelable
Operating
leases
Do not substantially transfer benefits and

risks of ownership
4
Accounting by Lessee
Capitalize
if noncancelable, and
Transfers ownership to lessee, or

Contains bargain purchase option, or
Lease term equal to 75% or more of
estimated economic life of property, or
PV of minimum lease payments equals or
exceeds 90% of fair value of property
5
Bargain Purchase Option

Allows
lessee to buy leased asset

Price significantly lower that expected
fair value at date of option
Determined at inception of lease
Must render option reasonably assured
Economic Life Test

Lease
period equals or exceeds 75% of

assets economic life
Lease term is considered the fixed
noncancelable term of lease
Bargain renewal options are included
If lease starts during last 25% of life of
asset, test cannot be used
8
Recovery of Investment
PV
of minimum lease payments equals

or exceeds 90% of fair value
Minimum lease payments
Payments
Guaranteed residual value
Penalty for failure to renew or extend
Bargain purchase option
9
Discount Rate
The
lesser of
Lessees incremental borrowing rate, or

The implicit interest rate
10
Executory Cost
Insurance,
maintenance and taxes

Should be excluded from minimum
lease payments
11
Residual Values
Estimated
fair value at end of lease

Guaranteed residual value
An additional lease payment
Unguaranteed
residual value
Same as no residual value to lessee

Lessor
assumes residual value will be

realized whether guaranteed or not
12
Capitalized Leases
Asset
and Liability
Recorded at the lesser of the PV of

minimum lease payments or FMV
Depreciation
Period
Economic life
Lease transfers ownership
Lease has bargain purchase option
Term of lease
13
Fact Pattern
Date: January 1, 2006

Lease term: 10 years
Discount rate: 8%
Annual lease payments: $12,000
Executory costs: $1,000
Title transfers at end of lease term
Economic life of asset: 12 years
Residual value: $0
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Operating Leases
Lessee
assigns rent to periods

benefiting
Ignores any commitments for future
payments
Note disclosure
For all operating leases that have
noncancelable lease terms in excess of one
year
19
Classification of Leases
Accounting by Lessor
Direct
financing leases
Sales type leases
Operating leases
20
Direct Financing Lease

Must
meet group I capitalization criteria
and
Collectibility of payments must be
reasonably assured
Lessors performance must be
substantially complete
FV
of asset equal to lessors book value

21
Sales Type Lease
Must meet group I capitalization criteria and

Collectibility of payments must be reasonably
assured
Lessors performance must be substantially
complete
FV of asset should not be equal to lessors

book value
Lease contains a dealers gross profit
22
Operating Lease
Does
not meet criteria for capitalized
lease
Rental receipts recorded as rental
receipts
Leased asset depreciated
Leased equipment and accumulated
depreciation separately classified
23
24
Direct Financing Lease

Debit,
Lease receivable
Gross sum of lease payments

Credit,
Unearned interest revenue
Lease receivable less FMV of asset

Credit,
Inventory of equipment
Lessors cost of the asset
25
Fact Pattern
Date:
January 1, 2005
Inventory of equipment: $103,500
Lease term: 6 years
Implicit interest rate: 8%
Payments: $20,000
Residual value: $5,786
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Sales Type Leases
Debit, Lease Receivable

Lease payments plus residual
Debit, Cost of Goods Sold

Lessors cost
Credit, Sales Price of Asset

PV of minimum lease payments
Credit, Unearned Interest Revenue

Lease Receivable less FMV of asset
Credit, Inventory
Lessors cost
29
Fact Pattern
Date:
January 1, 2005
Inventory of equipment: $60,000
FMV of equipment: $103,500
Lease term: 6 years
Implicit interest rate: 8%
Payments: $20,000
Residual value: $5,786
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Leases

Sid Glandon, DBA, CPA

Contractual agreement between lessor and

financing at fixed rates

If lease transfers substantially all of the

Do not substantially transfer benefits and

Transfers ownership to lessee, or

Bargain Purchase Option

lessee to buy leased asset

Economic Life Test

period equals or exceeds 75% of

of minimum lease payments equals

Lessees incremental borrowing rate, or

maintenance and taxes

fair value at end of lease

Same as no residual value to lessee

assumes residual value will be

Recorded at the lesser of the PV of

Date: January 1, 2006

assigns rent to periods

Direct Financing Lease

meet group I capitalization criteria

of asset equal to lessors book value

Sales Type Lease

Must meet group I capitalization criteria and

FV of asset should not be equal to lessors

not meet criteria for capitalized

Direct Financing Lease

Gross sum of lease payments

Unearned interest revenue

Lease receivable less FMV of asset

Lessors cost of the asset

Sales Type Leases

Debit, Lease Receivable

Debit, Cost of Goods Sold

Credit, Sales Price of Asset

Credit, Unearned Interest Revenue

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