Accounting for Leases

The Leasing Environment

• A lease is a contractual agreement between a lessor and a lessee.
• It grants the lessee the right to use specific property owned by the lessor for a specified period.
• Largest group of leased equipment involves:
  • Information technology equipment
  • Transportation (trucks, aircraft, rail)
  • Construction
  • Agriculture

Advantages of Leasing—Lessees

• 100% financing at fixed rates.
• Protection against obsolescence.
• Flexibility.
• Less costly financing.

Advantages of Leasing - Lessor

• Often provides profitable interest margins.
• It can stimulate sales of a lessor’s product.
• It often provides tax benefits to various parties in the lease.
• It can provide a high residual value to the lessor.

Lease Classification Tests

• Transfer of ownership test: Does the lease transfer ownership of the underlying asset to the lessee by the end of the lease term?
• Purchase option test: Does the lease grant the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise?
• Lease term test: Is the lease term for a major part of the remaining economic life of the underlying asset?
• Present value test: Does the present value of the sum of (1) the lease payments and (2) any lessee residual value guarantee not reflected in the lease payments equal or exceed substantially all of the underlying asset's fair value?
• Alternative use test: Is the underlying asset of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term?

Purchase Option Test

• A purchase option test is met if it is reasonably certain that the lessee will exercise the option.
• The lease purchase option allows the lessee to purchase the property for a price that is significantly lower than the underlying asset’s expected fair value at the date the option becomes exercisable.
• This is called a bargain purchase option.

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.

Present Value Test - 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, the lessee uses its incremental borrowing rate.

Alternative Use Test

• If at the end of the lease term the lessor does not have an alternative use for the asset, the lessee classifies the lease as a finance lease.
• The assumption is that the lessee uses all the benefits from the leased asset and therefore the lessee has essentially purchased the asset.

Lessor Accounting for Sales-Type 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 lessor has, in substance, transferred control of the right-of-use asset and therefore has a sales-type lease if the lessee takes ownership or consumes a substantial portion of the underlying asset over the lease term.
• On the other hand, if the lease does not transfer control of the asset over the lease term, the lessor will generally use the operating approach in accounting for the lease.

Lessor Accounting for Sales-Type Leases - Accounting Measurement and Presentation

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.
• the lease receivable is computed as shown

Special Lease Accounting Problems

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—Unguaranteed Residual Value

• A lessee does not include an unguaranteed residual value in the computation of the lease liability.
• At the end of the lease, the lessee simply returns the leased asset to the lessor without any other payment.

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.

Summary of Treatment of Residual Values

• Note: When residual value is not guaranteed in a sales-type lease, lessor reduces Sales Revenue and Cost of Goods Sold by the present value of the unguaranteed residual value.

Special Lease Accounting Problems

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.

Accounting for Operating Leases

Lessee 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.

Lessor Accounting for Operating Leases

• If a lease does not meet any of the lease classification tests for a sales-type lease, a lessor should classify it as an operating lease.
• For leases classified as operating, the lessor
  • Continues to recognize the asset on its balance sheet.
  • Recognizes equal amounts of rental revenue (straight- line basis) in each period.
  • Depreciates the leased asset on a straight-line basis over the asset’s remaining economic life.

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.

Special Lease Accounting Problems

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.