INTERMEDIATE

ACCOUNTING
Seventh Canadian Edition
KIESO, WEYGANDT, WARFIELD, YOUNG, WIECEK

Prepared by:
Gabriela H. Schneider, CMA
Northern Alberta Institute of Technology
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.
 Learning Objectives

15. Describe the lessee’s accounting for sale-

leaseback transactions (Appendix 21A).
16. Explain the classification and accounting
treatment accorded leases that involve land
as well as buildings and equipment
(Appendix 21A).
 Leases

Basics of Accounting by Lessees Accounting by Special Illustrations

Leasing Capitalization criteria Lessors Accounting of Lease
Advantages Accounting for a capital Economics of Issues Arrange-
of leasing lease leasing Residual ments
Conceptual Capital lease method Classification values Harmon,
nature of a illustrated Capitalization Inc.
Bargain
lease Reporting and criteria Arden’s
purchase
disclosure-capital Direct financing Oven Corp.
leases options
lease Initial direct Mendotta
Accounting for an Sales-type lease costs Truck Corp.
operating lease Operating leases Current Appleland
Reporting and
Reporting and versus Computer
disclosure-operating disclosure
leases noncurrent
Illustration of Unsolved
Perspectives lessor
Illustration of disclosures problems
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 (owned by the lessor)
• 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 or divided
 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
 Differing Views on
Capitalization of Leases
Do not capitalize any leased assets
– Since lessee does not own the property,
capitalization is considered inappropriate
– Since executory contracts are not capitalized,
leases should not be either
Capitalize leases that are similar to instalment
purchases
– If instalment purchases are capitalized, so
should leases with similar characteristics
 Differing Views on
Capitalization of Leases
Capitalize all long-term leases
– The long-term right to use property justifies its
capitalization (property rights approach)
Capitalize firm leases where the penalty for
nonperformance is substantial
– Capitalize only “firm” or non-cancellable
contractual rights and obligations
 Current Accounting Standard

• CICA standard is consistent with approach

similar to instalment purchases
• A lease that transfers substantially all the
benefits and risks of property ownership
should be capitalized
 Current Accounting Standard

Basic Conclusions:
1. Characteristics indicating transfer of risks
and benefits of ownership must be identified
2. Same characteristics should apply to the
lessee and lessor
3. Leases that do not transfer substantially all
benefits and risks of ownership should not
be capitalized
 Lease Classification

• Capital Lease
– Where the benefits 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:
• 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 estimated and 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 rate lessor used
to calculate the lease payment, and it is less
than the lessee’s incremental borrowing rate
– In this case, use implicit 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
– Otherwise over the term of the lease
 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
• 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. Obligations under capital lease
To record interest amortization
Using the Effective
Dr. Interest Expense
Interest Method
Cr. Interest Payable
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. Obligations under capital lease
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 Value
Transfer of  75% of of Payments 
Ownership No Economic Life? 90% of Fair
or Bargain Value?
Purchase
Option? Yes
PV of payments (n=5, i=10%)
Yes 25,981.62 - 2000.00 =
Capital Lease 23,981.62 x 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 1/05)

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, 2005)
Interest Expense 7,601.84
Interest Payable 7,601.84
(100,000-23,981.62)*10% = 7,601.84
(Interest Payable is debited in all subsequent lease payment entries)

• Asset amortization (December 31, 2005)

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 related accumulated
amortization
• Amortization expense may be disclosed, methods and
rate should be disclosed
• Lease obligations reported separately from other
liabilities
• Current portion of lease obligation=current liability
• 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
unreim-
Risk burseable
Yes Does Asset
associated Yes costs to Fair Value =
with collection Lessor
Lessor’s
normal? estimatible?
Does Lease Book 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

• Lessor replaces investment in asset to be leased

with a lease receivable
• Over lease term, the receivable is collected, and
interest is earned
• Net investment in the lease = lease payments
receivable – unearned interest revenue
 Calculation of Lease Payment by
Lessor
Step 1:
Calculate the payment required to provide lessor with
required rate of return

Cost/FMV of asset to be recovered $100,000

Less: PV of expected residue value -0-
Amount to be recovered through
lease payments $100,000
 Calculation of Lease Payment
(Cont’d)
Amount to be recovered $100,000

Payments: (n=5, i=10) $100,000

4.16986

= $23,981.62

Lease payments receivable:

5 x $23,981.62 = $119,908.10
 Direct Financing Lease (Lessor)

• The lease payments 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:
 Direct Financing Lease (Lessor)
January 1, 2005
Lease Payments Receivable 119,908.10
Equipment for Lease 100,000.00
Unearned Interest Revenue 19,908.10
January 1, 2005 (first payment)
Cash ($23,981.62+$2,000) 25,981.62
Property Tax Expense 2,000.00
Lease Payments Receivable 23,981.62
December 31, 2005
Unearned Interest Revenue 7,601.84
Interest Revenue 7,601.84
 Direct Financing Lease (Lessor)
At Dec. 31/05 year end, Lessor recognizes interest
earned:
Amount originally financed $100,000.00
Paid on principal Jan. 1/05 (23,981.62)
Balance outstanding $ 76,018.38
Interest : 10% x 76,018.38 x 12/12
= $7,601.84
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
• Lessor earns a gross profit on sale +
interest as the sale is financed
 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 cost 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, 2005
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, 2005 (first payment-remains the same)
Cash ($23,981.62+$2,000) 25,981.62
Property Tax Expense 2,000.00
Lease Payments Receivable 23,981.62
December 31, 2005 (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 amortization of the property
– Amount of rental (lease) income earned
 Other Lease Accounting Issues

• Residual Value – Lessor

– 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 (and
COGS) if guaranteed
 Other Lease Accounting Issues

• Residual Value – Lessee

– If guaranteed by lessee, p.v. of residual is
included in asset cost and lease obligation
recognized (i.e. is included in definition of
minimum lease payments)
– If not guaranteed by lessee, residual value is
not included in definition of minimum lease
payments – not in asset or liability amounts
recognized
 Other Lease Accounting Issues

• Bargain Purchase Option

– With direct financing and sales-type leases, the
bargain purchase price is included in the net
investment calculations by Lessor
– Lessee accounting assumes bargain option price
will be paid: p.v. of amount included in asset cost
and obligation recognized
 Initial Direct Costs of Lessor

• Application of Matching Principle

– Operating lease – over term of lease
– Direct financing lease – over term of lease
– Sales-type lease – in same period as gross
profit on sale recognized
 Current and Noncurrent

• Current portion = principal amount to be

received/paid within 12 months from balance
sheet date + interest accrued to the balance
sheet date
• Long-term = principal amount not
recoverable/payable within 12 months from
balance sheet date
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