Chapter 4

Accounting for Leases

The Leasing Environment

According to FASB, a lease is an agreement conveying the right to use
property, plant, and equipment (PP&E) usually for a stated period of time.

A lease is a contractual agreement between a lessor and a lessee. This

arrangement gives the lessee the right to use specific property, owned by
the lessor, for a specified period of time. In return for the use of the
property, the lessee makes rental payments over the lease term to the
lessor.

Leases can be broadly classified as either operating leases or capital

leases. If the lease agreement transfers a “material ownership interest”
from the lessor to the lessee, it is a capital lease. If not, it is an operating
lease.

Operating Leases
Operating leases are the simplest type of lease arrangement from an
accounting viewpoint. The rentals are considered to be revenue to the
owner-lessor and expenses to the tenant-lessee. If rentals are received in
advance, they should be recorded as unearned rent (a liability) by the lessor
and as prepaid rent (an asset) by the lessee. As time goes by, adjusting
entries should be made to slowly recognize these items as revenue and
expense, respectively. In addition, the lessor should be the one to record the
annual depreciation entry since the asset still belongs to him or her.

To illustrate assume that on January 1, 2015, Lessor rents a building for 3

years to Lessee at a fixed rental of $6,000 per year. The total rental of
$18,000 is received immediately. The building cost Lessor $25,000 and has a
life of 5 years with no salvage value. The entries for year 1 are:
Lessor Lessee
Jan. 1: Cash ------18,000 Prepaid Rent ------18,000
Unearned Rent ------ Cash ----------------18,000
18,000

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Dec. 31: Unearned Rent ------ 6,000 Rent Expense ------ 6,000
Rent Revenue Prepaid Rent ------ 6,000
-----------6,000
Dec. 31: Depreciation Expense------ No entry
5,000
Acc. Depreciation
-------------5,000
On December 31, 2016 and 2017, entries would once again be made by both
parties to recognize $6,000 as revenue and expense, respectively.

If there are any initial direct costs incurred by the lessor in consummating
the lease agreement, they should be debited to an intangible asset account
and then gradually be amortized and matched against the annual revenue.
Such costs include legal fees, credit report fees, accounting fees, and
commissions.

To illustrate assume that if in the previous example Lessor incurred $600 of

initial direct costs, then Lessor would make the following entry:
Lease Initiation Fees -------------- 600
Cash --------------------------------------- 600
In addition, Lessor would also make the following entry each December 31:
Lease Initiation Expense ---------- 200
Lease Initiation Fees ------------------ 200*
(∗600 ÷ 3)
Capital Leases

If a lease agreement fulfills certain conditions that indicate a transfer of a

“material ownership interest” has taken place, the lease requires special
accounting treatment. Material ownership interest has been defined as a
transfer of most of the risks and rewards of ownership.

Fulfillment of anyone of the following conditions indicates a material

ownership interest:

1. The lease agreement transfers title to the lessee at the end of the
lease term.
2. The lessee has the option of buying the asset at a bargain price
(“bargain purchase option” or “BPO”) at the end of the lease term.

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 3. The present value of the annual annuity of rentals is greater than, or
equal to, 90% of the fair market value of the asset at the lease
inception date.
4. The lease term is equal to 75% or more of the asset’s life.

What is the “special accounting treatment” required if any one of the above
conditions is met? The answer is that we “make-believe” the lessor sold this
asset, instead of merely renting it. Thus, each payment is not a “rental”
payment, but an installment payment on the purchase price.

Legally, this transaction is a rental; in economic substance, however, it is a

sale. To ignore the economic substance would make this company’s financial
statements incomparable to the statements of companies that made a “real”
sale.

In addition to the four conditions mentioned earlier, two additional conditions

must both be met for the lessor to treat this transaction as a sale. They are:

1. Collectability of the lease payments must be reasonably assured.

2. No important uncertainties surround the amount of unreimbursable
costs yet to be incurred by the lessor under the lease agreement.

Leases that meet any one of the four conditions mentioned (and the two
additional conditions for the lessor) are referred to as capital leases. There
are two types of capital leases: direct financing and sales-type.

In a direct financing lease, the lessor does not make a profit at the time of
sale; in a sales-type the lessor does.

Example:

Lessor rents a building with a life of 4 years to Lessee for 3 years. Let’s
assume that the two special conditions for the lessor have been met.
This is considered a capital lease since the lease life is 75% of the
building’s life.

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Lessor rents a building with a life of 4 years to Lessee for 2 years. Thus
the 75% test has not been met. However, the fair market value of the
building is $100,000 and the present value of the rentals is $92,000.
Since the present value is greater than or equal to 90% of the fair
market value, this is a capital lease.
Lessor rents a building to Lessee that has a cost to Lessor of $100,000.
If the present value of the lease payments is greater than $100,000,
then Lessor has made a profit and the lease is thus considered to be a
sales-type lease.

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Direct Financing Leases

As mentioned previously, if the lease agreement meets the necessary

conditions for a capital lease and the lessor does not make a profit on the
sale, the lease is a direct financing lease, and the asset is considered to have
been sold. Each annual payment on the lease is not a rental payment, but a
partial payment of the purchase price obligation. Interest accrues annually
on this obligation and must be recorded.

The Lessee will record the asset at the present value of the annual lease
payments, and will also record the depreciation. However, if the present
value exceeds the asset’s fair market value, then the fair market value
should be used instead.

The annual lease payment is determined by the lessor using the following
formula:

Selling price
Present value of annuity, at rate i, for n periods
To illustrate assume that lessor leases a building to Lessee for 4 years
starting January 1, 19A. Both the cost to Lessor and the selling price are
$50,000. There will be four lease payments, with the first one starting
immediately on January 1, 19A. (Thus we are dealing with an annuity due
situation.) The building has a 4-year life with no salvage value. Lessor’s
target rate of return is 10%. This lease meets the 75% test (the lease term is
at least 75% of the life—here it is 100% of the life) and is therefore, a capital
lease. Using the above formula, the annual lease payment is:

$50,000
Present value annuity due, 10%, 4 periods
= $50,000
3.48685
= $14,339.59
Both the lessor and lessee will make entries on their books indicating that a
sale/purchase has taken place. The lessor will credit the asset and debit a

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receivable; the lessee will debit the asset and credit a payable for the
present value of the annuity of lease payments.

If the lessee is not aware of the target rate used by the lessor, then the
lessee should use his or her own “incremental borrowing rate”—the rate the
lessee would pay to borrow funds in the market. If the lessee is aware of the
lessor’s target rate, then he or she should use the lower of the two rates.

To illustrate let’s assume in the previous example that both rates are 10%.
The following entries will be made by both parties for 19A:

Lessor Lessee
Jan. 1, Lease Receivable -----50,000 Building ------------50,000
19A Building -------------------- Lease Payable ----------- 50,000
50,000
Jan. 1, Cash -----------------14,339.59 Lease Payable --------14,339.59
19A Lease Receivable -------- Cash ----------------------------
14,339.59 14,339.59
Dec. 31, Lease Receivable ------- Interest Expense --------- 3,566.04
3,566.04* Lease Payable -----------------
19A Interest Revenue ------ 3,566.04
3,566.04
*($50,000 − 14,339.59) × 10%
Dec. 31, No entry for depreciation Depreciation Expense --------12,500*
expense Accumulated Depreciation -------
19A 12,500
*$50,000 ÷ 4 years
The entries for the following years would be the same except that the
amount for the interest entry would change. It is helpful to prepare an
amortization table to determine the annual interest and Lease Receivable/
Payable balances.

If we use the same information as in the previous examples, the amortization

table would appear as follows:

(1) (2) (3) (4) (5)

Date Payment Interest Change in Balance of
Receivable/ Receivable/Paya
Payable ble
Jan. 1, $50,000.00
19A
Jan. 1, $14,339.59 $(14,339.59) 35,660.41
19A

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 Dec. 31, $3,566.04 3,566.04 39,226.45
19A
Jan. 1, 14,339.59 (14,339.59) 24,886.86
19B
Dec. 31, 2,488.69 2,488.69 27,375.55
19B
Jan. 1, 14,339.59 (14,339.59) 13,035.96
19C
Dec. 31, 1,303.60 1,303.60 14,339.56
19C
Jan. 1, 14,339.59 (14,339.59) -0-
19D (rounded)
Column 3 is the balance of column 5 multiplied by 10%. To column 5 we add
the interest accrual, and subtract the lease payment.

In addition to annual lease payments, a lease agreement may require the

lessee to pay the annual costs of maintaining the asset. These costs include
insurance, security, maintenance, etc. Such costs should not be capitalized
by the lessee as part of the cost of the asset but should be considered an
expense of the period. These costs are called executory costs.

Sales-Type Leases

In a sales-type lease the lessor sets a selling price above the asset cost, thus
recognizing an immediate profit at the inception of the lease. Accordingly,
the selling price, not the cost, will be used in the numerator in determining
the annual rentals, and the amortization table will be based on this price as
well.

To illustrate assume that lessor leases a machine having a 3-year life to

Lessee for a 3-year lease period. The cost to Lessor was $20,000; the selling
price is $25,000. The annual rentals begin immediately on January 1, 19A,
and Lessor’s two conditions have been set. Lessor’s target rate of return is
10% and this rate is known to Lessee. However Lessee’s own incremental
rate is 12%. Because Lessor’s rate of 10% is the lower of the two rates, it
must also be used by Lessee. The annual rental is computed as follows:

$25,000

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 Present value annuity due, 10%, 3 periods
= $25,000
2.73554
= $9,138.96

The entries for 19A are:

Lessor Lessee
Jan. 1 Lease Receivable -------25,000 Machine -------------------25,000
Machine Lease Payable ----------------- 25,000
------------------------20,000
Profit on Lease
-----------------5,000
Jan. 1 Cash ---------------9,138.96 Lease Payable --------- 9,138.96
Lease Receivable ---------- Cash -----------------------------
9,138.96 9,138.96
Dec. 31 Lease Receivable ------- Interest Expense -----------1,586.10
1,586.10 Lease Payable -------------------
Interest Revenue 1,586.10
------------1,586.10
Dec. 31 No entry Depreciation Expense ------- 8,333.33*
Acc. Depreciation ----------------------
8,333.33
*25,000 ÷ 3
The amortization table would appear as follows:
Date Payment Interest Change in Balance of
Receivable/Pay Receivable/
able Payable
Jan. 1, 19A $25,000.00
Jan. 1, 19A $9,138.96 $(9,138.96) 15,861.04
Dec. 31, $1,586.10 1,586.10 17,447.14
19A
Jan. 1, 19B 9,138.96 (9,138.96) 8,308.18
Dec. 31, 830.82 830.82 9,139.00
19B
Jan. 1, 19C 9,138.96 (9,138.96) -0-
(rounded)
For both direct financing and sales-type leases, the lease agreement may
specify that under certain conditions the lease terminates early and the

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asset reverts back to the lessor. In these cases, the lessor will debit the asset
at the lower of its original cost or present fair market value, remove the
lease receivable, and recognize any gain or loss. The lessee will also remove
the lease payable from his or her books and recognize a loss or gain as well.

To illustrate assume that, in the previous example assume that the lease
terminates on December 31, 19A, when the balance of the lease
receivable/payable is $17,447.14. The fair market value of the machine at
this point is $15,000. The entries are:

Lessor Lessee
Machine --------------------------------- Lease Payable --------------17,447.14
15,000 Acc. Depreciation ----------8,333.33
Loss on Lease Termination------ Gain on Lease Termination -----
2,447.14 Lease 780.47
Receivable ------------------------ Machine ------------------------------
17,447.14 25,000

Bargain Purchase Options

In all the previous examples, the asset had no salvage value at the end of
the lease term. If it does have a salvage value, the lease agreement may
sometimes specify that the lessee has the option of either returning the
asset at that date or purchasing the salvage value at a bargain price. This is
called a bargain purchase option (BPO).

When such an option exists, the lessor assumes that the lessee will indeed
take advantage of this bargain and purchase the asset (because few people
pass up a bargain!). Thus the lessor expects two types of cash flows from
this lease agreement:

1. The annuity of annual rentals

2. The purchase price at lease termination (not an annuity)
Accordingly, in the determination of the annual rental, the lessor must first
subtract the present value of the bargain payment.

To illustrate assume that a lessor enters into an agreement with Lessee on

January 1, 19A, for the 3-year rental of a machine. The machine has a 4-year
life with a salvage value of $7,000 after 3 years and zero at the end of 4

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years. Lessor’s cost and selling prices are both $30,000. The interest rate for
both parties is 10%. Lessee has an option to purchase this machine after 3
years for a bargain price of $5,000. There are no uncertainties regarding
collection of rentals or future costs, and the first payment is due on January
1, 19A.

This lease qualifies as a capital lease for both parties (direct financing type)
since there are no cost uncertainties & it meets two of the four conditions
mentioned earlier.

Lessor calculates the annual rental as follows:

Selling price -------------------------------------------------------------------
$30,000.00
Less Present value of $5,000, 3 periods, 10%:
(0.75131 × $5,000) -------------------------------------------------------
3,756.55
Amount to be recovered from annual rentals -----------------------------
$26,243.45
This amount is now divided by the present value of an annuity for 3 periods
at 10%, as follows:
Annual rental = $26,243.45
2.73554
= $9,593.52
The entries for both parties in 19A are:
Lessor Lessee
Jan. 1 Lease Receivable --------- Machine 30,000
30,000 Lease Payable -------------------
Machine 30,000
---------------------------30,000
Jan. 1 Cash ----------------------9,593.52 Lease Payable 9,593.52
Lease Receivable Cash ------------------------------
--------------9,593.52 9,593.52
Dec. 31 Lease Receivable ----- Interest Expense 2,040.65
2,040.65 Lease Payable ------------------
Interest Income 2,040.65
-------------2,040.65
Dec. 31 No entry Depreciation Expense 7,500*
Acc. Depreciation -----------------
7,500
*30,000 ÷ 4
Notice that Lessee uses a 4-year life for depreciation purposes because we
assume that the bargain purchase option will be exercised.

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The amortization table is as follows:
Date Payment Interest Change in Balance of
Receivable/Pay Receivable/Pay
able able
Jan. 1, 19A $30,000.00
Jan. 1, 19A $9,593.52 $(9,593.52) 20,406.48
Dec. 31, $2,040.65 2,040.65 22,447.13
19A
Jan. 1, 19B 9,593.52 (9,593.52) 12,853.61
Dec. 31, 1,285.36 1,285.36 14,138.97
19B
Jan. 1, 19C 9,593.52 (9,593.52) 4,545.45
Dec. 31, 454.55 454.55 5,000.00
19C

Notice the $5,000 balance in the Lease Receivable/Payable account at this

point. This is the bargain purchase option. If Lessee now exercises this
option, the entries are:

Lessor Lessee
Dec. 31, 19C Cash --------------5,000 Lease Payable ----------5,000
Lease Receivable Cash ---------------------------5,000
----5,000
If not, the asset reverts back to Lessor, who would record it at its fair market
value of $7,000, and the entries would be:

Lessor Lessee
Machine --------------------------7,000 Lease Payable ------------------------5,000
Lease Receivable Loss on Lapse of Lease Option --2,500
--------------------------5,000 Accumulated Depreciation -----22,500
Gain on Lapse of Lease Option Machine --------------------------------
-------2,000 30,000

Sale And Leasebacks

If the owner of an asset sells it and then immediately leases it back from the
buyer, this is referred to as a sale-leaseback, and the seller then continues to
use the property without interruption.

The accounting profession has ruled that in this situation any gain on the
sale should be deferred and recognized piecemeal over the life of the lease.

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If not for this restriction, the seller-lessee could sell the asset to the buyer-
lessor for an unrealistic price in order to report a large gain on the sale. The
seller-lessee could then lease the asset back at annual rentals whose present
value is equal to the original selling price. The result is the reporting by the
seller-lessee of a large “phantom” gain, despite his or her being in the same
economic position as before. In order to prevent this, FASB No. 13 requires
that the two transactions (sale and leaseback) be treated as a single
transaction with the gain deferred.

It should be noted that, while gains are deferred, losses are recognized
immediately. If the lease meets the necessary criteria to be considered a
capital lease, the gain is recognized gradually as a reduction of the annual
depreciation expense. If not, it is considered a reduction of the annual rent
expense.

Sale and finance leaseback

Any excess sale proceeds over carrying amount is deferred and amortised
over the lease term

Sale and operating leaseback

If the:

• proceeds = fair value: recognise profit or loss immediately

• proceeds < fair value: recognise profit or loss immediately unless

future lease payments are below market value, defer loss and amortise
it

• proceeds > fair value:

1. recognise the excess of the fair value over carrying amount

immediately as profit

2. defer the excess of the proceeds over fair value and amortise it
over the period of lease term.
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To illustrate assume that Seller-Lessee sells an asset to Buyer-Lessor on
January 1, 19A, for $100,000, and immediately leases it back for a 3-year
period at a 10% interest rate. Seller-Lessee’s original cost was $80,000 (thus
the gain on the sale is $20,000) and the asset has no salvage value. Let’s
assume the criteria for a capital lease are not met and, accordingly, the
lease is an operating lease.
The annual lease payment is:
$100,000
2.73554
= $36,556 (rounded)

The entries in the first year for both parties are:

Seller-Lessee Buyer-Lessor
Jan. 1 Cash -------------- 100,000 Asset ------------------100,000
Asset Cash --------------------------100,000
---------------------------------80,000
Unearned Gain on
Sale-Leaseback*
------------------20,000
Jan. 1 Rent Expense ------------- Cash ---------------------36,556
36,556 Rent Revenue ------------------36,556
Cash
--------------------------------36,556
Dec. 31 No entry Depreciation Expense --------33,333.33*
Acc. Depreciation -----------------
33,333.33
*(100,000 ÷ 3)
Dec. 31 Unearned Gain No entry
on Sale-Leaseback-------
6,667.67
Rent Exp. (20,000 ÷ 3)
------6,667.67
*This is a liability account similar to
other unearned accounts

In the previous example, if the lease qualified as a capital lease, the entries
would be:
Seller-Lessee Buyer-Lessor
Jan. 1 Cash ------------100,000 Asset -------------------100,000
Asset ------------------------- Cash ---------------------------100,000

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80,000
Unearned Gain on-
Sale-Leaseback ------------
20,000
Jan. 1 Asset ------------100,000 Lease Receivable -------100,000
Lease Payable ---------- Asset -------------------------100,000
100,000
Jan. 1 Lease Payable --------36,556 Cash -------------------36,556
Cash ------------------------ Lease Receivable -------------36,556
36,556
Dec. 31 Interest Expense* ---- Lease Receivable --------6,344.40
6,344.40 Interest Revenue --------------
Lease Payable ------------ 6,344.40
6,344.40
*(100,000 − 36,556)0.10
Dec. 31 Depreciation Expense------ No entry
33,333.33
Acc. Depreciation
---------33,333.33
Dec. 31 Unearned Gain on- No entry
Sale-Leaseback --------
6,667.67
Depreciation Expense
-----6,667.67
There is one exception to the above stated rule that gains on sales-
leasebacks be deferred. If the leaseback is a “minor leaseback” then the gain
would be recognized immediately. In a minor leaseback, the present value of
the payments is ten percent or less of the asset’s fair market value.

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