Comprehensive Notes on Leases - Chapter 15
Background
Leases: A contractual arrangement featuring two parties:
Lessor: The owner of the asset (provider of the lease).
Lessee: The user or operator of the leased asset.
Purpose: Allows the lessee certain rights to control the use of an asset in exchange for periodic cash payments.
Reasons for Leasing
Companies might choose to lease rather than purchase assets for several operational, financial, and tax incentives:
Reduced Upfront Cash: Leasing minimizes initial cash outflow needed to use an asset.
Lower Payments: Lease payments can be less than installment payments associated with purchasing.
Flexibility in Disposal: Leasing allows for easier and potentially lower-cost disposal of assets after use.
Protection from Declining Values: Leasing can mitigate risks associated with falling asset values over time.
Tax Advantages: Certain lease payments may be tax-deductible, providing fiscal benefits.
Lease Terms and Classifications
Key Definitions:
Lessee: The user/operator of the leased asset(s).
Lessor: The owner of the leased asset(s).
Operating Lease: A lease where fundamental rights and responsibilities of ownership remain with the lessor (temporary use by the lessee).
Finance Lease / Sales-Type Lease: The lessee assumes significant rights and responsibilities, possibly leading to asset ownership.
Lease Classification Overview
Categories for Lessee and Lessor:
Finance Lease
Sales-type Lease: Can include profit from sales (with or without selling profit).
Operating Lease: Remaining items in the categories of leases.
Lease Classification Criteria
A lease is considered a Finance/Sales-Type Lease if it meets any of the following five criteria:
The lease agreement states ownership of the asset transfers to the lessee.
The agreement contains a purchase option, which the lessee is likely to exercise (bargain purchase option).
The lease term lasts for a major part of the asset’s remaining economic life (defined as 75% of useful life).
Present value of minimum lease payments equals or exceeds “substantially all” of the fair value of the asset.
The asset is specialized with no alternative use to the lessor at lease end.
Legal Ownership: It is important to note that legal ownership is not a determinant in lease classification.
Finance/Sales-Type Lease vs. Sale/Purchase of Asset
Differences:
Lessee cannot sell the leased asset. (e.g., car financed via a dealership).
Similarities:
Lessee can determine how to use the asset and has obligations similar to ownership obligations.
Application of Classification Criteria: Example
Case Study: On January 1, 2022, Sans Serif Publishers leased printing equipment from First LeaseCorp.
Cost of Equipment: $479,079 (purchased by First LeaseCorp from CompuDec Corp).
Lease Payments: Six annual payments of $100,000 beginning from January 1, 2022.
Lease Term: Six-year lease ending December 31, 2027 (matches estimated useful life).
Interest Rate for Purchase: 10% (as if it was borrowed to buy equipment).
Applying Criteria
Ownership Transfer: No.
Purchase Option: No.
Economic Life: Yes (lease term equals the life).
Present Value: Yes ($479,079 meets minimum threshold).
Alternative Future Use: No.
Conclusion: Since at least one criterion is satisfied, this would classify as a Finance/Sales-Type Lease.
Present Value of Lease Payments
Payments include:
Six payments of $100,000 starting January 1, 2022.
Interest rate for present value calculation: 10%.
Adjustment: Payments at the beginning necessitate modifying the formula used for calculation.
Formula for Present Value Calculation:
ext{PMT} = 100,000
ext{i} = 10 ext{%}
ext{NPER} = 6
The present value calculation incorporates the present value formula for an annuity due.
100,000 imes 4.79079 = 479,079
Practice Exercise
Question: Identify classification criteria for finance leases from the following scenarios:
a. Asset has alternative future use after the lease.
b. Lessee can purchase the asset at market price plus 10% at end of lease.
c. Lease term=8 years, asset life=9 years.
d. PV of minimum lease payments = 70% of asset’s fair value.
Recording the Lease: Example
Setting: On January 1, 2022, lease agreement for printing equipment:
Payment Terms: Six payments of $100,000.
Cost Basis: $479,079.
Interest Rate: 10%.
Journal Entries:
For Sans Serif (Lessee):
Right-of-use asset (PV of lease payments): 479,079 .
Lease payable: 479,079 .
For First LeaseCorp (Lessor):
Lease receivable: 479,079 .
Equipment (cost): 479,079 .
First Lease Payment
On January 1, 2022, First Lease Payment Includes:
Lessee's Entry:
Debit: Lease payable - 100,000.
Credit: Cash (lease payment) - 100,000.
Lessor's Entry:
Debit: Cash (lease payment) - 100,000.
Credit: Lease receivable - 100,000.
Second Lease Payment Entries
For both lessee and lessor, it’s essential to calculate the interest expense based on the outstanding principal:
Remaining Principal Calculations: ( 479,079 - 100,000 ) = 379,079 .
Interest Expense Calculation: ( 379,079 imes 10 ext{%} ) = 37,908 .
Journal Entries for Second Payment
Sans Serif (Lessee):
Interest expense: 37,908 .
Lease payable (debt part): 62,092 .
Cash (payment): 100,000 .
First LeaseCorp (Lessor):
Cash (payment): 100,000 .
Lease receivable (debt part): 62,092 .
Interest revenue: 37,908 .
Lease Amortization Schedule
Example Entries of Interest and Balance Oversight:
Date
Interest Expense
Payments
Decrease in Balance
Outstanding Balance
1/1/2022
-
100,000
–
379,079
12/31/2022
37,908
100,000
62,092
316,987
12/31/2023
31,699
100,000
68,301
248,686
12/31/2024
24,869
100,000
75,131
173,555
12/31/2025
17,355
100,000
82,645
90,910
12/31/2026
9,090
100,000
90,910
0
Discount Rate in Lease Accounting
Concept: The implicit rate is used in present value calculations for the associated lease commitments.
Reflects the expected return rate considered by the lessor when formulating lease payment quantities.
If Unknown: If lessor's rate is not discernible, the lessee utilizes its incremental borrowing rate via a bank or other financial source.
Practice Exercise and Interest Reporting
Example Case: A Consulting firm leases machinery with the present value calculated for leasing payments as 40.5 million at a 10% rate. Calculate the interest expense reported in December 31, 2025's income.
Amortization of Leased Asset
Core Idea: The lessee, upon recognizing a leased asset during a fixed duration, is required to record amortization expenses.
Similarity to depreciation for Property, Plant, and Equipment (PPE).
Amortization typically is recorded using the straight-line method over the duration of the lease.
If ownership transfers, or it is likely for the exercise of a purchase option, the asset amortization extends over its useful life.
Journal Entry for Amortization
Example Visualization:
Recording on December 31, 2022 – amortization expense = 79,847 ; therefore:
Debit: Amortization expense - 79,847.
Credit: Right-of-use asset - 79,847.
Calculation: 479,079 / 6 ext{ years} = 79,847 .
Practice Exercise (Morris Investments)
Present value of lease payments discounted at 10% was $80,000 with ten lease payments of 12,000 due.
Determine the total decrease in earnings pretax in December 31, 2022 statement.
Sales-Type Leases with Selling Profit
Definition: This occurs when the present value of lease payments exceeds the original cost or book value of the asset.
Accounting Implications:
The lessor acknowledges a profit at the lease's commencement (as sales revenue and cost of goods sold).
Interest revenue recognition patterns remain consistent over the lease period.
Lessee’s entries remain unaffected in terms of financial impacts relative to cost-recognition.
Sales-Type Lease Example
On January 1, 2022, Sans Serif leases from CompuDec:
Lease Payments: Six payments of 100,000 .
Present Value of Payments: Calculated at 479,079 based on the interest rate of 10%.
Lessor's Entries:
Lease receivable - 479,079.
Cost of goods sold (lessor cost) - 300,000.
Sales revenue (lease payments accounted for) - 479,079.
Practice Exercise (LeaseCo Industries)
Equipment leased for $810,000 with lease payments of 120,000 over 10 annuity terms.
Reflect on the increase in earnings reported for December 31, 2022.
Operating Leases
Summary: An operating lease does not meet any criteria for finance leases; ownership rights and responsibilities remain with the lessor while the lessee uses the asset temporarily.
The lessor's entries focus on recording revenue straight-line.
The lessee acknowledges a right-of-use asset and a lease payable at commencement based on the PV of lease payments.
Lease payables are not considered debt liabilities but obligations nonetheless.
Operating Lease Example
Upon leveraging a lease agreement, for four annual payments of 100,000 during the operational period:
At commencement, both recognized amounts should stand equal at 348,685 .
Journal Entries (Operating Lease)
For Payments:
Lessee recognizes payment as a lease expense - 100,000 , while the lessor maintains a deferred revenue counter until same is recognized at the year’s end.
Amortization Schedule Operating Lease
Visual Entries: Interest paid and balance decrease consistent with overall payment structure.
Reporting Lease Expense and Revenue
After transactions are recorded:
The lessee combines interest and amortization expense into singular lease expense statement.
For operating leases, it targets straight-line expense while differentiating from finance leases, which lists them separately in income statements.
Short-Term Leases
A shortcut accounting method can be utilized for leases defined by:
Maximum term of 12 months without a purchase option intended for exercise.
Lessee Elections:
May choose not to acknowledge the right-of-use asset or related liabilities or simply expense the lease payments during the effective period.
Lease Agreement Examples
Include quarterly payment instances with vast parallels to reporting methodologies alongside operational life standardizations.
Residual Value
Definition: The expected value at lease end minus all anticipated costs for disposal.
Implications: On both operating and finance-type leases influencing payment sizes, classifications of lease agreements, and recognizing amounts appropriately.