Leases

What is a finance/capital lease?

1. 1 of 5 conditions must be met in order for a lease to be classified as a finance lease. If none of the five are met that indicates an operating lease! See picture below for additional details regarding the five conditions for a finance lease.

2. If there is a question regarding lease criteria, and there is an option to purchase, do not assume that this automatically meets a finance lease criteria, the question must indicate that this is a bargain purchase option.

3. Finance lease applies only to the lessee, operating lease can be for the lessor or the lessee.

Leases notes

1. Expenses under finance lease:

   a. Interest expense.

   b. Amortization expense.

2. When calculating lease payments, the lessee includes the following:

   a. The exercise price of a purchase option that the lessee is reasonably certain to exercise.

   b. The purchase price at the end of the lease.

   c. Residual guarantees likely to be owed.

   d. Termination penalties reasonably assured.

Lease term test.

1. See picture below for information regarding bargain renewal option.

2. Ignore tax terminology, example tax depreciation. You are not concerned with taxes only the accounting useful life/economic life of the asset when determining the 75% test.

Cash flow statement

See picture.

Present value test

See picture below for additional information regarding the present value test.

What are the 5 things to be met for a finance lease?

1. Transfer of ownership

2. Purchase option

3. Lease term equals 75% of economic life of least property

4. Present value of lease payments is greater than 90% of fair market value of asset

5. Alternative use test

Journal entries for Lessee – Finance lease

1. Your entry must include an asset as well as a liability.

2. Record the right of use asset and lease liability

   a. DR: ROU Asset $xx

   CR: Lease Liability $xx

3. If first payment is immediate:

   a. DR: lease liability $XX.

   CR: Cash. $XX

   (immediate payment is all principal, no interest)

4. Any amounts paid by the lessee to cover cost such as repairs, maintenance, insurance exp and taxes, are not included as part of the lease payments.

   a. Those are executory costs that will be expensed.

5. Guaranteed residual value:

   on the exam, any guaranteed residual value gets included in the minimum lease payment. The same goes for bargain purchase option. (Note: only the difference between the guarantee and the expected value is included. Example: guaranteed residual value = $6,000. Expected value at the end of the lease = &1,000. Only $5,000 is included. (Present value of $5,000))

6. If the guarantee residual value is expected to be worth the same amount at the end of the lease term, then there is nothing to include. (Ex: guarantee residual value is $10,000 and is expected to be worth $10,000 at the end of the lease term.)

1. Guaranteed residual value - Cont’d

1. Lessee guarantees $10,000 and lessee estimates that the car will likely be worth $2000 at end of the lease, then $8000 guaranteed residual to capitalize.

2. Lessee guarantees the car will be worth $10,000 an estimates that the car will be worth zero at the end of the lease term. Then the full $10,000 of the guaranteed residual needs to be capitalized.

See picture below for an example of an amortization chart and the affiliated journal entry. Also, see sample question and answer.

1. See picture below.

2. Note: Amortization Expense is the Present Value or ROU Assets/ periods. ( ex: present value = $25,771, periods = 3 Years, Amortization Expense = $8,590.6)

Finance leases: what is the initial journal entry to record the lease on the books?

Debit to ‘Right of use asset’.

Credit to ‘lease liability’.

Finance leases, what’s the journal entry to record the first lease payment?

Debit: lease liability

Credit: cash

Finance leases how to determine the right of use asset amount?

This is the present value of the lease.

1. Multiply the lease payment amount by the present value factor of either an ordinary annuity or an annuity due, to determine the right of use asset amount. Know how to calculate both factors.

2. Note: when advertising the right of use asset, use the shorter of the lease life, or the asset life.

Finance lease_lease amortization schedule. What’s the journal entry required to record amortization of the right of use asset?

The right of use asset is the present value of your lease liability, if it’s straight line divide that amount by the number of years. The journal entry is:

1. a debit to amortization expense, and

2. a credit to right of use asset.

For finance lease, what are the two expenses that are recognized?

1. Interest expense using the effective interest method

2. Amortize (amortization expense) the asset on the right of use using straight line method see picture below.

Operating lease

1. Note: One Income Statement Expense “Lease Expense” is applicable to Operating Lease.

2. The lease last longer than a year, but does not meet one of the five requirements for a finance lease.

3. Asset and liability must be recorded on the lessee’s books at lease inception.

4. See picture below.

Operating lease - Cont’d

1. At lease inception, lessee records a Debit: “Right of Use” (asset), and a Credit: “Lease liability“.

2. The preferred interest rate to use in the present value calculation is the lessor’s implicit rate, if known.

3. If the lessor’s rate is not known, then the lessee will use the lessee’s incremental borrowing rate.

4. Note: remember for operating leases (unlike Finance Lease), we do NOT separately recognize interest expense. The only expense is the lease expense.

5. You do need to calculate the interest expense, because you will need to know what amount to reduce the carrying amount of your lease obligation by.

Operating lease Example (Ordinary Annuity)

1. For the first payment, there will be 2 journal entries.

   a. DR: Lease Expense $xx

   CR: Cash. $xx

   b. DR: Lease Liability $xx (principal portion)

   CR: Right of Use Asset $xx (amortization)

Operating lease Example (Annuity Due)

1. For an annuity due (immediate first lease payment), your initial j/e is the same as with an ordinary annuity:

   a. DR: ROU Asset

   CR: Lease Liability

2. You would also make an entry to record the first payment:

   a. DR: Lease Liability $xx (all principal)…no interest has accrued on day 1 so you are taking the full principal.

   CR: Cash $xx

3. Note: the right of use asset is not impacted by this immediate payment.

4. At the end of the year, even though no payment is being made, you still need to record the lease expense:

   a. DR: Lease Expense $xx

   CR: Lease Liability. $xx

   CR: ROU Asset. $xx

Operating lease - Final Payment

Operating lease - Bargain Purchase Option

Formula for the present value of an ordinary annuity.

PVIFA = (1-(1 + i) ^-n)/ i

Complete in this order,

1. (1 + .04) ex: 1.04

2. ^-5 ex: =power(1.04,-5) = 0.8219271

3. 1 - 0.8219271 =0.178

4. 0.178/ 0.04 =4.4518

5. 4.4518 × 1.04 = 4.6299 (this last step is because it is an annuity due)

   Steps 1 thru 4 is for an ordinary annuity.