Leases - Chapter 15 Review
Leases Study Notes
Chapter 15 Overview
Subject: Leases
Institution: Penn State, Smeal College of Business
Background
Definition of a Lease: A lease is a contractual arrangement where one party (lessor) grants another party (lessee) the right to control and use an asset in exchange for periodic cash payments.
Lessor: The owner of the asset
Lessee: The user of the asset
Reasons Companies Choose to Lease
Operational, Financial, and Tax Incentives: Leasing presents several advantages over purchasing assets:
Reduced Upfront Cash: Leasing decreases the amount of cash needed to utilize an asset initially.
Lower Payments: Lease payments are often less than installment payments for purchases.
Flexibility and Cost Efficiency: Leasing provides flexibility and often lowers costs when it comes to disposing of the asset.
Protection Against Depreciation: Leasing may protect lessees from declines in asset value.
Tax Benefits: Leasing might provide various tax advantages.
Lease Terms
Lessee: The entity that operates the leased asset.
Lessor: The entity that owns the leased asset.
Types of Leases:
Operating Lease: The lessor retains most ownership rights, and the lessee temporarily uses the asset.
Finance Lease (Sales-Type Lease): The lessee obtains significant rights to the asset, and ownership risks and rewards are transferred.
Overview of Lease Classifications
Lessee Classification:
Finance Lease
Sales-Type Lease:
Lease with selling profit
Lease without selling profit
Operating Lease
Lease Classification Criteria
A lease is classified as a Finance / Sales-type lease if it meets one or more of the following criteria:
Ownership of the asset transfers to the lessee by the end of the lease term.
The agreement includes a purchase option that the lessee is likely to exercise (bargain purchase option).
The lease term covers the major part (75%) of the asset's economic life.
The present value (PV) of the lease payments is at least substantially all of the fair value of the asset.
The asset is specialized with no alternative use for the lessor at the end of the lease term.
Legal Ownership Irrelevance: Legal ownership is not the sole criterion for lease classification.
Finance/Sales-Type Lease vs. Sale/Purchase of an Asset
Differences:
The lessee does not have the right to sell the asset.
Similarities:
Lessee controls the asset's use and bears obligations comparable to owning it.
Example Application of Lease Classification Criteria
Scenario: On January 1, 2022, Sans Serif Publishers leased printing equipment from First LeaseCorp. The asset's purchase price was $479,079 with six annual payments of $100,000, totaling a lease term of six years ending December 31, 2027.
Analysis:
Ownership Transfer: No
Purchase Option: No
Lease Term: Yes (6 years equals economic life)
PV vs Fair Value: Yes ($479,079 PV of payments equals fair value)
Alternative Use: No
Conclusion: The lease qualifies as a finance/sales-type lease due to meeting multiple criteria.
Present Value of Lease Payments Calculations
Initial Payments: The agreement has six annual payments of $100,000, with an implied borrowing rate of 10%.
Adjustment in Present Value Calculation: Adjust the formula for an annuity due since payments are at the beginning of each year.
Variables:
PMT = $100,000
i = 10%
NPER = 6
Present Value Calculation:
PV = 100,000 imes 4.79079 = 479,079
Present Value of an Annuity Due: Calculated based on $1 for n=6, i=10%.
Example of Interest Expense in Second Lease Payment
Scenario: Calculation for second lease payment involves outstanding principal and interest rate.
Outstanding Principal: $379,079
Interest Expense Calculation:
Interest\,Expense = 10\% \times (479079 - 100000) = 37907.90
Lease Amortization Schedule
Payments Over Time: Reflects interest and principal balance reduction.
Sample Data:
Date
Payment
Interest Expense
Decrease in Balance
Remaining Balance
1/1/2022
100,000
-
-
379,079
12/31/2022
100,000
37,908
62,092
316,987
12/31/2023
100,000
31,699
68,301
248,686
12/31/2024
100,000
24,869
75,131
173,555
12/31/2025
100,000
17,355
82,645
90,910
12/31/2026
100,000
9,090
90,910
0
Concept of Discount Rates in Lease Accounting
Implicit Rate: The rate used to determine the present value of lease payments.
Incremental Borrowing Rate: When the implicit rate is not known to the lessee, they should use the rate at which they can borrow from a financial institution.
Amortization of Leases
Amortization Expense: Similar to depreciation for other assets, recorded similarly across financial leases and operating leases.
Finance Lease: Amortized over the term of the lease or asset's useful life if ownership transfer occurs.
Operating Lease: Typically recorded as lease expense following straight-line principles.
Journals Entries for Amortization:
Finance Lease Example:
December 31, 2022:
Amortization Expense: $79,847
Right-of-Use Asset: $79,847
Practice Exercises and Examples
Practical Scenarios: Various practice exercises are provided throughout, requiring students to apply lease classification criteria, calculate present value, interest expense entries, and amortization schedules.
Distinguishing Finance versus Operating Leases
Amortization Differences:
In finance leases, total expenses are front-loaded while, in operating leases, they remain consistent.
Total expenses should be accounted differently for the lessee respectively across lease types.
Short-Term Leases
Short-Cut Method Criteria: Applicable for leases with a term of 12 months or less without purchase options.
Lessee may opt not to record a right-of-use asset or lease liability, treating lease payments as an expense.
Documentation Example: No entry to record value as lease term is short, only expense when payment occurs.
Residual Value
Definition: The expected amount received for the asset at the end of its life after costs.
Importance: Informs lease payment sizing, lease classification, and recorded amounts for both lessee and lessor.
Conclusion
Comparison of Lease Types: Essential for understanding the treatment and effects of leases on financial statements for both lessors and lessees, considering different forms of leases, payments, and the broader implications under financial reporting standards.