Accounting for Leases

Learning Objectives

• Understand the environment related to leasing transactions.

• Explain the accounting for finance leases.

• Explain the accounting for operating leases.

• Discuss the accounting and reporting for special features of lease arrangements.

The Leasing Environment

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

• Gives the lessee the right to use specific property, owned by the lessor, for a specified period of time.

• Largest group of leased equipment involves:

  • Information technology equipment

  • Transportation (trucks, aircraft, rail)

  • Construction

  • Agriculture

Advantages of Leasing – Lessees

1. 100% financing at fixed rates.

2. Protection against obsolescence.

3. Flexibility.

4. Less costly financing.

Advantages of Leasing – Lessor

1. Often provides profitable interest margins.

2. It can stimulate sales of a lessor’s product.

3. It often provides tax benefits to various parties in the lease.

4. It can provide a high residual value to the lessor.

Lease Classification - Lessee

• From the lessee’s perspective, a lessee should classify a lease based on whether the arrangement is effectively a purchase of the underlying asset.

• If the lease transfers control (or ownership) of the underlying asset to a lessee, then the lease is classified as a finance lease.

  • The lessee takes ownership or consumes the substantial portion of the underlying asset over the lease term.

• All leases that do not meet any of the finance lease tests are classified as operating leases.

• For a finance lease:

  • Must be non-cancelable and

  • Meet at least one of the five tests

Lease Term Test

• If the lease term is 75 percent or greater of the economic life of the leased asset, the lease meets the lease term test and finance lease treatment is appropriate (75% test).

• Lease term is generally considered to be the fixed, non-cancelable term of the lease.

• Bargain-renewal option can extend this period.

• At the commencement of the lease, the difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably certain.

Present Value Test

• Lease Payments:

  • Fixed payments.

  • Variable payments that are based on an index or a rate.

  • Guaranteed residual value.

  • Payments related to purchase or termination options that the lessee is reasonably certain to exercise.

Discount Rate

• Lessee should compute the present value of the lease payments using the implicit interest rate.

  • This rate, at commencement of the lease, which causes the aggregate present value of the lease payments and unguaranteed residual value to be equal to the fair value of the leased asset.

• In the event that it is impracticable to determine the implicit rate, a company uses its incremental borrowing rate.

Finance Leases (Lessee)

• For a finance lease:

  • The lessee recognizes interest expense on the lease liability over the life of the lease using the effective-interest method and

  • Records amortization expense on the right-of-use asset generally on a straight-line basis.

Lessor Accounting for Leases

• The lease classification tests for the lessor are identical to the tests used by the lessee to determine classification of a lease as a financing or operating lease.

• The basic difference between a direct financing lease and a sales-type lease relates to the profit on the sale.

  • In a sales-type lease, the profit is recognized immediately.

  • In a direct financing lease, the profit is deferred and recognized over the life of the lease.

Lessor Accounting for Sales-Type Leases

• For a sales-type lease:

  • The lessor accounts for the lease in a manner similar to the sale of an asset.

  • The lessor generally records a Lease Receivable and eliminates the leased asset.

Accounting for Operating Leases

• If a lease does not meet any of the lease classification tests for a finance lease, a lessee should classify it as an operating lease.

• For leases classified as operating, the lessee records

  • A right-of-use asset and lease liability at commencement of the lease, similar to the finance lease approach.

  • However, unlike a finance lease, the lessee records the same amount for lease expense each period over the lease term.

• For an operating lease:

  • The lessee also measures interest expense using the effective-interest method.

  • However, the lessee amortizes the right-of-use asset such that the total lease expense is the same from period to period.

  • Only a single lease expense (comprised of interest on the liability and amortization of the right-of-use asset) is recognized on the income statement.

• Applying the same classification tests used by the lessee and classify the lease as an operating lease if none of the finance lease tests are met. Under the operating method, the lessor

  • Continues to recognize the asset on its balance sheet and recognizes lease revenue (generally on a straight-line basis) in each period.

  • Depreciates the leased asset on its income statement.

Special Lease Accounting Problems

1. Residual values.

2. Other lease adjustments.

3. Bargain purchase options.

4. Short-term leases.

5. Presentation, disclosure, and analysis.

Residual Values

Lessee Perspective—Guaranteed Residual Value

The guidelines for accounting for a guaranteed residual value are, if it is probable that the expected residual value is

• equal to or greater than the guaranteed residual value, the lessee should not include the guaranteed residual value in the computation of the lease liability.

• less than the guaranteed residual value, the difference between the expected and guaranteed residual values should be included in computation of the lease liability.

Lessee—Guaranteed Residual Value

• To illustrate a situation where the expected residual value is below the guaranteed residual value, assume in the earlier Caterpillar(lessor)/Sterling(lessee) example that it is probable that the residual value will be 3,000 instead of the guaranteed amount of 5,000. If Sterling(lessee) estimates the residual value of the backhoe at the end of the lease to be 3,000, Sterling includes 2,000 (5,000 − $3,000) as an additional lease payment in determining the lease liability and right-of-use asset.

Lease Amortization Schedule for Lessee Guaranteed Residual Value

• Sterling prepares a lease amortization schedule.

• (a) Lease payment as required by lease.

• (b) Four percent of the preceding balance of (d) except for 1/1/17; since this is an annuity due, no time has elapsed at the date of the first payment and therefore no interest has accrued.

• (c) (a) minus (b).

• (d) Preceding balance minus (c).

• Rounded by 0.11.

Journal Entries—Guaranteed Residual Value

• In comparative form, Sterling’s entries for the first two years of the lease when Sterling expects to pay 2,000 at the end of the lease and when Sterling does not expect to owe an additional payment.

At the end of the lease term (January 1, 2022), Sterling returns the asset to Caterpillar and makes the following entries under the two situations.

Final Payments—Guaranteed and Unguaranteed Residual Value

• Assume Sterling and Caterpillar agree that the fair value of the asset is sufficiently below the expected fair value such that Sterling must pay an additional 1,000 upon returning the backhoe to Caterpillar on January 1, 2022. In this case, Sterling makes the following entry.

• Lease Liability 2,000

• Loss on Lease (Residual Value Guarantee) 1,000

• Cash 3,000

Lessee—Unguaranteed Residual Value

• A lessee does not include an unguaranteed residual value in the computation of the lease liability, whether it is a finance lease or an operating lease.

• At the end of the lease, the lessee simply returns the leased asset to the lessor without any other payment.

Lessor—Guaranteed Residual Value

• In the Sterling/Caterpillar example, Sterling (lessee) guaranteed a residual value of 5,000. In computing the amount to be recovered from the rental payments, the present value of the residual value was subtracted from the fair value of the backhoe to arrive at the amount to be recovered by the lessor.

• This computation is the same whether the residual value is guaranteed or unguaranteed.

Lessor—Unguaranteed Residual Value

• In this case, there is less certainty that the unguaranteed residual portion of the asset has been “sold.”

  • The lessor recognizes sales revenue and cost of goods sold only for the portion of the asset for which recovery is assured.

  • Both sales revenue and cost of goods sold are reduced by the present value of the unguaranteed residual value.

  • The gross profit computed will still be the same amount as when a guaranteed residual value exists.

• To compare a sales-type lease with a guaranteed residual value to one with an unguaranteed residual value, assume the same facts as in the Caterpillar/Sterling lease situation. That is:

  1. The sales price is 100,000.

  2. The expected residual value is 5,000 (the present value of which is 4,109.65).

  3. The leased equipment has an 85,000 cost to the dealer, Caterpillar.

Lessor-Unguaranteed Residual Value

Computation of Lease Amounts by Caterpillar

Entries for Guaranteed and Unguaranteed Residual Values Sales-Type Lease

Summary of Treatment of Residual Values

Other Lease Adjustments

• Executory Costs are normal expenses associated with owning a leased asset, such as property insurance and property taxes.

  • Executory costs included in the fixed payments required by the lessor should be included in lease payments for purposes of measuring the lease liability.

  • Payments by the lessee made directly to the taxing authority or insurance provider are considered variable payments and are expensed as incurred.

Lease Prepayments and Incentives

• Companies adjust the right-of-use asset for any lease prepayments, lease incentives, and initial direct costs made prior to or at the commencement date.

  1. Lease prepayments made by the lessee increase the right-of- use asset.

  2. Lease incentive payments made by the lessor to the lessee reduce the right-of-use asset.

  3. Initial direct costs incurred by the lessee (discussed in the next section) increase the right-of-use asset.

Initial Direct Costs

• are incremental costs of a lease that would not have been incurred had the lease not been executed.

• Examples of costs included and excluded from initial direct costs from the lessee and lessor side.

• Initial direct costs incurred by the lessee are included in the cost of the right-of-use asset but are not recorded as part of the lease liability.

• Lessor accounting for initial direct costs depends on the type of lease.

  • For operating leases, a lessor defers the initial direct costs and amortizes them as expenses over the term of the lease.

  • For sales-type leases, the lessor expenses initial direct costs at lease commencement (in the period in which it recognizes the profit on the sale).

Bargain Purchase Option

• Allows the lessee to purchase the leased property for a future price that is substantially lower than the asset’s expected future fair value.

• If a bargain purchase option exists, the lessee must increase the present value of the lease payments by the present value of the option price.

Short-Term Leases

• A lease that, at the commencement date, has a lease term of 12 months or less.

• Rather than recording a right-of-use asset and lease liability, lessees may elect to expense the lease payments as incurred.

• Renewal or termination options that are reasonably certain of exercise by the lessee are included in the lease term.

Presentation, Disclosure, and Analysis

Presentation in Financial Statements—Lessee

Summary of how the lessee reports the information related to finance and operating leases in the financial statements.

Presentation in Financial Statements—Lessor

Summary of how the lessor reports the information related to sales -type and operating leases in the financial statements.

Qualitative Lease Disclosures

Lessees and lessors must also provide additional qualitative and quantitative disclosures to help financial statement users assess the amount, timing, and uncertainty of future cash flows.
Qualitative disclosures to be provided by both lessees and lessors are summarized below.

Lessee Quantitative Disclosures

Below are the type of quantitative information that should be disclosed for the lessee.

Lessor Quantitative Disclosures

Below presents the type of quantitative information that should be disclosed for the lessor.

Analysis

• With the increase in the assets and liabilities, a number of financial metrics used to measure the profitability and solvency of companies will change.

  • Return on assets will decrease.

  • Earnings before interest, taxes, and depreciation and amortization (EBIDTA), which likely will require some adjustments as companies amortize right-of-use assets.

  • Debt to equity ratio will increase, and the interest coverage ratio will decrease.

IFRS Insights

Similarities

• Both GAAP and IFRS share the same objective of recording leases by lessees and lessors according to their economic substance—that is, according to the definitions of assets and liabilities.

• Much of the terminology for lease accounting in IFRS and GAAP is the same.

• Both GAAP and IFRS require lessees to recognize a right-of-use asset and related lease liability for leases with terms longer than one year.

• Under both IFRS and GAAP, lessors use the same general criteria (consistent with the recent standard on revenue) to determine if there is transfer of control of the underlying asset and if lessors classify leases as sales-type or operating.

• GAAP and IFRS have similar qualitative and quantitative disclosure requirements for lessees.

Differences

• There is no classification test for lessees under IFRS 16. Thus, lessees account for all leases using the finance lease method—that is, leases classified as operating leases under GAAP will be accounted for differently compared to IFRS.

• IFRS allows alternative measurement bases for the right-of-use asset (e.g., the revaluation model, in accordance with IAS 16, Property, Plant and Equipment).

• In addition to the short-term lease exception, IFRS has an additional lessee recognition and measurement exemption for leases of assets of low value (e.g., personal computers, small office furniture).

• IFRS does not include any explicit guidance on collectibility of the lease payments by lessors and amounts necessary to satisfy a residual value guarantee.

• IFRS does not distinguish between sales-type and direct financing leases for lessors. Therefore, IFRS 16 permits recognition of selling profit on direct financing leases at lease commencement.

• IFRS applies to leases of any asset, whether tangible plant, property, or intangible assets. GAAP applies only to tangible plant property.

• IFRS uses the same model for leases for both lessees and lessors, whereas GAAP uses a different model for lessees and lessors.