INTERMEDIATE

ACCOUNTING
Sixth Canadian Edition
KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK

Prepared by
Gabriela H. Schneider, CMA; Grant MacEwan College
CHAPTER

21
Leases
 Learning Objectives
1. Explain the nature, economic substance, and
advantages of lease transactions.
2. Identify and explain the accounting criteria and
procedures for capitalizing leases by the lessee.
3. Identify the lessee’s disclosure requirements for
capital leases.
4. Identify the lessee’s accounting and disclosure
requirements for an operating lease.
 Learning Objectives
5. Contrast the operating and capitalization methods
of recording leases.
6. Calculate the lease payment required for the
lessor to earn a given return.
7. Identify the classifications of leases for the lessor.
8. Describe the lessor’s accounting for direct
financing leases.
9. Describe the lessor’s accounting for sales-type
leases.
 Learning Objectives
10. Describe the lessor’s accounting for operating
leases.
11. Identify the lessor’s disclosure requirements.
12. Describe the effect of residual values,
guaranteed and unguaranteed, on lease
accounting.
13. Describe the effect of bargain purchase options
on lease accounting.
14. Describe the lessor’s accounting treatment for
initial direct costs.
 Leases

Basics of Accounting by Accounting by Special Illustrations

Leasing Lessees Lessor Accounting of Lease
Capitalization Economics of Issues Arrangements
Advantages criteria leasing
Residual Harmon, Inc.
of leasing Accounting for a Classification values
capital lease Capitalization
Conceptual Bargain Arden’s Oven
Capital lease criteria purchase
nature of a method illustrated Corp.
Direct financing options
lease Reporting and lease Initial direct Mendotta
disclosure-capital Sales-type lease costs Truck Corp.
leases Operating leases Current
Accounting for an Reporting and versus Appleland
operating lease disclosure noncurrent Computer
Reporting and Illustration of Unsolved
disclosure- lessor problems
operating lease disclosures
Illustration of
disclosures
 Leasing: Basics

• The lease is a contractual agreement

between the lessor and the lessee
• The lease gives the lessee the right to use
specific property
• The lease specifies also the duration of the
lease and rental payments
• The obligations for taxes, insurance, and
maintenance may be assumed by the lessor
or the lessee
 Advantages of Leasing
• 100 percent financing at a fixed rate
• No down payment required
• Rate charged is fixed for the term of the lease
• Protection from obsolescence
• Property can be upgraded
• Flexibility
• Lease may be structured to meet different needs
(e.g., cash flow)
• Less costly financing (lessee); tax incentives
(lessor)
• Off-balance sheet financing
• Impact on ratios
 Lease Classification

• Capital Lease
• Where the rights and risks of ownership
have effectively been transferred to the
lessee
• Accounted for as a purchase by the lessee
• Journal Entries:
Lessee Lessor
Leased Equipment XXX Lease Receivable (net) XXX
Lease Obligation XXX Equipment XXX
 Lease Classification
• Operating Lease
• Where the rights and risks of ownership
have not been transferred
• A rental-only has occured
• Journal Entries:
Lessee Lessor
Lease Expense XXX Cash XXX
Cash XXX Rental Revenue XXX
 Capital vs. Operating Lease
Lease
Agreement

Is there a Is Lease Term  No

No Is Present No
Transfer of 75% of Value of
Ownership Economic Life Payments 
or Bargain
90% of Fair
Purchase
Value
Option?
Yes Yes Yes

Capital Lease Operating

Lease
 Capital Lease Criteria
• Transfer of ownership
• Economic life
• PV of payments
• If the PV of minimum lease payments is  90% of
the fair value of the asset
• minimum lease payments (lessee) defined as:
• Minimum rental payments +
• Guaranteed residual value +
• Penalty for not renewing or extending lease +
• Bargain purchase option
 Minimum Lease Payments
• Minimum rental payments
• Regular payment made to lessor, excluding
executory costs
• Executory costs include insurance, maintenance and
tax expenses
• If these payments made by the lessor, they are
excluded from the minimum rental payment calculation
• Guaranteed residual value
• The amount at which the lessor has the right to
require the lessee to purchase the asset; or
• The amount the lessee (or 3rd party guarantor)
guarantees that the lessor will realize
 Discount Rate
• The rate the lessee would have incurred if
they had borrowed the funds to purchase the
asset (incremental borrowing rate)
• Under similar term (length)
• Similar security (same type of asset)
• This rate is not used when
• The lessee knows the implicit borrowing rate
lessor used to calculate the lease payment, and
• The implicit borrowing rate is less than the
incremental borrowing rate
 Accounting for a
Capital Lease
• Asset and liability recorded at the lower of:
• PV of the minimum lease payments (as defined above)
or
• Fair value of the asset at the inception of the lease
• Depreciation of the asset is amortized over:
• The economic life of the asset if ownership transfers
to lessee at the end of the lease or there is a bargain
purchase option
• The term of the lease if title does not transfer or there
is no bargain purchase option
 Accounting for a
Capital Lease
• Interest expense resulting from the lease
transaction is recorded following the
effective interest method
• The discount rate used to establish the initial
PV is used to amortize the lease discount
• Journal entries required to record a capital
lease transaction are as follows:
 Accounting for a
Capital Lease
At the inception of the lease
Dr. Asset
Cr. Lease Liability
To record interest amortization Using the
Dr. Interest Expense Effective
Cr. Interest Payable Interest Method
To record asset amortization Using method
Dr. Amortization Expense appropriate to
Cr. Accumulated Amortization the asset
To record the lease payment
Dr. Related Executory Expense (if any)
Dr. Interest Payable
Dr. Lease Liability
Cr. Cash
 Capital Lease - Example
Lease Terms Given:
• Term of 5 years, non-cancellable
• Annual payments $25,981.62 (due at beginning of each
year)
• Fair value of asset $100,000
• Economic life = 5 years Residual value = Zero
• Lease payments include $2,000 property taxes (executory
cost)
• Lease has no renewal option, and asset reverts to Lessor
at termination of lease
• Lessee’s incremental borrowing rate = 11%
• Lessor’s implicit rate =10% (known to lessee)
 Capital Lease - Example

• Does this qualify as a capital lease?

• Only one of the tests must be met
Is there a Is Lease Term Is Present
Transfer of  75% of Value of
Ownership No Economic Payments 
or Bargain Life? 90% of Fair
Purchase Value?
Option? Yes
PV of payments (n=5, i=10%)
Yes 25,981.62 - 2000.00 =
Capital Lease 23,981.62 * 4.16986 =
$100,000.00
 Capital Lease - Example
• Entry to record initial lease transaction
Leased Equipment 100,000
Lease Liability 100,000
• Entry to record initial payment (Jan 1/02)
Property Tax Expense 2,000.00
Lease Liability 23,981.62
Cash 25,981.62
• As this is a capital lease the following must also
be recorded (at year end or in each reporting period)
• Interest expense
• Asset amortization
 Capital Lease - Example
• Interest amortization (December 31, 2002)
Interest Expense 7,601.84
Interest Payable 7,601.84
(100,000-23,981.62)*10% = 7,601.84
(Interest Payable is debited, and becomes part of all
subsequent lease payments)

• Asset amortization (December 31, 2002)

Amortization expense 20,000
Accumulated amortization 20,000
(100,000 ) / 5 years = 20,000)
(There is no transfer of ownership or bargain purchase
option, so the term of the lease is used to amortize the
asset)
 Disclosure Requirements –
Capital Lease
• Gross amount of assets and accumulated
amortization
• Depreciation expense may be disclosed, methods
and rate should be disclosed
• Lease obligations reported separately from other
liabilities
• Current portion of lease obligation
• Minimum lease payments in total and for the next
five fiscal years; executory costs and imputed
interest disclosed separately
• Interest expense from the lease may be separately
disclosed; or included with other interest expense
• May disclose any related contingencies
 Accounting by the Lessor

• Leases are classified as either:

• Operating Lease
• Direct financing Lease These are
• Sales-type Lease capital leases

• The determination of a capital or operating

lease depends on answering a series of
questions
 Lease Classification - Lessor
Lease
Remaining
Agreement
unreimbur-
Risk seable costs
Yes Does Asset
associated Yes to Lessor Fair Value =
with collection estimatible?
Lessor’s Book
Does Lease normal? Value?
No
meet any of
Lessee’s No Yes
Yes
Capital
Direct
Lease
No Financing
criteria?
Lease
No
Operating Sales-Type
Lease Lease
 Lease Classification - Lessor
• Both the direct financing lease and the sales-
type lease are capital leases
• The difference is whether or not there exists
a manufacturer’s or dealer’s profit
• The sales-type lease incorporates a profit –
hence the final question on the previous map
• A lease may qualify as a capital lease by the
lessee and as an operating lease by the lessor
 Direct Financing Lease - Lessor

• Accounting entries are a virtual mirror

image of the capital lease entries for the
lessee
• A couple of differences:
• The lease payment must first be calculated
• The discount rate used to establish the
Receivable is the rate of return of the lessor
• Unearned Interest Revenue is credited with
the difference between the Receivable and the
Asset credit
 Capital Lease –
Example (Lessor)
• Step One – Calculate the annual lease payment
required to provide the required rate of return
Cost (FMV) $100,000
Less: PV of the Salvage 0
Amount to be Recovered $100,000

• Payments would then be:

$100,000 = $23,981.62
1.46986 Annuity due factor for n=5, i=10%
• Total payments receivable = 5 * 23,981.62
= 119,908.10
 Capital Lease –
Example (Lessor)
• The lease payment receivable are equal to:
Lease payments (net of executory costs) +
salvage (residual) value
• The unearned interest revenue is the
difference between the lease payment
receivable and the asset cost (FMV)
• The journal entries are then:
 Capital Lease –
Example (Lessor)
• January 1, 2002
Lease Payments Receivable 119,908.10
Equipment for Lease 100,000.00
Unearned Interest Revenue 19,908.10
• January 1, 2002 (first payment)
Cash ($23,981.62+$2,000) 25,981.62
Executory Costs 2,000.00
Lease Payments Receivable 23,981.62
• December 31, 2002
Unearned Interest Revenue 7,601.84
Interest Revenue 7,601.84
 Sales-Type Lease - Lessor

• Entries are the same as for the direct

financing lease, except for:
• Entry at the inception of the lease must
record the sale and cost of goods sold
• Recall that the sales-type lease includes a
manufacturer’s/dealer’s profit margin
 Sales-Type Lease – Example

• Take the same data as in our example,

except the asset has been recorded in
the Lessor’s inventory at a value of
$85,000 (FMV=$100,000)
• All previous lessor entries remain the
same except for the entry at the lease
inception
• Sales and Gross Profit are recorded
 Sales-Type Lease – Example
• January 1, 2002
Lease Payments Receivable 119,908.10
Sales 100,000.00
Unearned Interest Revenue 19,908.10
Cost of Goods Sold 85,000.00
Inventory 85,000.00
• January 1, 2002 (first payment-remains the same)
Cash ($23,981.62+$2,000) 25,981.62
Executory Costs 2,000.00
Lease Payments Receivable 23,981.62
• December 31, 2002 (remains the same)
Unearned Interest Revenue 7,601.84
Interest Revenue 7,601.84
 Disclosure Requirements -
Lessor
• Disclose the net investment in the lease
(classified as current and non-current)
• How the investment is calculated for
purposes of income recognition
• Finance income amount

• Operating Leases
• Separate disclosure of the cost and
accumulated depreciation of the property
• Amount of rental (lease) income earned
 Other Lease Accounting Issues
• Residual Value
• Direct Financing Lease: whether guaranteed or
unguaranteed, the residual is included in the lessor
calculations
• Sales-Type Lease: with unguaranteed residual value
the Sales Revenue and COGS are reduced by the PV of
that unguaranteed residual value
Residual value is part of Sales Revenue if guaranteed
• Bargain Purchase Option
• With direct financing and sales-type leases, the bargain
purchase price is included in the net investment
calculations
• Direct Costs of Lessor
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