Leases

DERRICK BONYUET

Clinical Assistant Professor of Accounting, The University of Texas at Austin

FINANCIAL ACCOUNTING & STANDARDS I

Chapter 15: Leases

LEASING OVERVIEW

Why Lease? (LO15-1)

• Leasing presents various operational, financial, and tax benefits that make it a preferred choice over purchasing an asset. The specific advantages include:
    1. Reduced Upfront Cash Requirement: Leasing decreases the capital expenditure required to utilize an asset.   2. Lower Lease Payments: Monthly or periodic lease payments typically cost less than equivalent installment payments for purchases.   3. Flexibility: Leases allow for easier disposal of assets after the lease term.   4. Protection Against Depreciation: Leasing can hedge against the decline in asset values.   5. Tax Advantages: Certain leases may provide tax benefits versus ownership.

LEASE CLASSIFICATIONS

Classification Types and Roles (LO15-1)

• Leases are categorized for accounting as follows:   - Lessee:     - Finance Lease (transfers risks and rewards of ownership)     - Operating Lease (does not transfer ownership risks)   - Lessor:     - Sales-type Lease (with selling profit)     - Sales-type Lease (without selling profit)     - Operating Lease   - In specific scenarios, a lease may qualify as a “direct financing” lease instead of an operating lease.

LEASE CLASSIFICATION CRITERIA

Criteria for Classification of Leases

• Five key criteria determine whether a lease is classified as a finance/sales-type lease:   1. Ownership Transfer: The lease agreement includes a provision for ownership transfer to the lessee.   2. Purchase Option: There is a purchase option that the lessee is likely to exercise (a bargain purchase option).   3. Lease Term: The term is for the "major part" of the economic life of the asset.   4. Present Value of Payments: The present value of rental payments equals or exceeds "substantially all" of the asset’s fair value.   5. Specialized Asset Use: The asset has minimal alternative use to the lessor after the lease expires.

COMPARISON OF FINANCE LEASES AND INSTALLMENT NOTES

Recording Finance Leases

• At Beginning of the Lease (January 1):   - Debit Machinery $666,633   - Credit Notes Payable $666,633   - Debit Right-of-use Asset $666,633   - Credit Lease Payable $666,633

• Note: Finance leases resemble installment purchases, reflecting an asset acquisition financed either through a note or lease.

First Semiannual Payment (June 30) Entries

• Debit Interest Expense ($666,633 at 7%) $46,664

• Credit Notes Payable (remaining balance difference) $93,193

• Debit Interest Expense ($666,633 at 7%) $46,664

• Credit Lease Payable (remaining balance difference)

• Cash Payment: Total payment of $139,857

• Impact: Interest accrued reduces the principal balance.   

Payment Schedule (Detailed Example)

ILLUSTRATION OF LEASE CLASSIFICATION CRITERIA

Case Study: Sans Serif Publishers and First LeaseCorp (LO15-2)

• Lease Details:   - On January 1, 2024, Sans Serif leased printing equipment valued at $479,079 with six payments of $100,000 due annually starting January 1, 2024.   - Lease ends on December 31, 2029, matching the equipment's useful life.   - The lessor financing rate is 10%.

Application of Classification Criteria (LO15-2)

Criteria Evaluation:

1. Ownership transfer: No

2. Purchase option: No

3. Lease term matches useful life: Yes

4. PV of payments vs fair value: Yes (PV of annuity due: $100,000 x 4.79079 = $479,079)

5. Alternative use post-lease: No

• Conclusion: Since one criterion is met, this classifies as a finance/sales-type lease.

JOURNAL ENTRIES FOR LEASE PAYMENTS

Under Finance Lease (Sans Serif as Lessee)

First Payment Entry (January 1, 2024)

  - Debits: Lease Payable $100,000   - Credits: Cash $100,000

First Payment Entry (First Lease Payment)

  - Debits: Interest Expense ($10% * [$479,079 - 100,000]) $37,908   - Lease Payable remaining: $62,092   - Cash Payment: $100,000

Amortization Schedule Calculation

OPERATING LEASES

Definition and Criteria (LO15-4)

• Operating Lease Characteristics:   - Does not meet criteria for finance lease.   - The lessor retains ownership rights.   - No sale is recorded by the lessor; lease revenue recorded straight-line.   - Lessee recognizes a right-of-use asset and lease payable based on present value of payments.   - Lease liability is treated as non-debt liability.

Example: Operating Lease with Sans Serif and First LeaseCorp

• Lease Specifications:
     - Four annual payments of $100,000, starting January 1, 2024.    - Present value of payments calculated: $348,685 (based on 10% discount).

• Accounting Treatment:   - Lease recognized as operating lease since none of the criteria for finance/sales-type leases are satisfied.   - Journal Entry on Lease Commencement (January 1, 2024):
       - Debit: Right-of-use Asset $348,685      - Credit: Lease Payable $348,685

• First Payment Entry: Similar to finance lease with adjustments in recorded accounts.

Lease Amortization Schedule for Operating Lease

COMPARISON OF LESSEE’S EXPENSE RECOGNITION

Finance Lease vs Operating Lease (LO15-4)

• Finance Lease Approach (Variable Interest & Amortization):   - 2024: Total Expense: 112,040 (Interest 24,869 + Amortization 87,171)

• Operating Lease Approach (Straight-Line):   - 2024: Total Expense: 100,000

• This comparison shows the differences in how expenses manifest under the two forms of leasing.

REAL-WORLD APPLICATION

Example: Dell Technologies Inc.

• Operating lease revenue is recognized over the lease term while ensuring that revenue from sales-type leases aligns with present values at lease commencement.

• Additional income from financing is recognized as product revenue throughout the lease duration.

PROBLEMS AND SCENARIOS

Lessor Able Problem A

• Overview of a lease agreement and computations related to initial lease liability, economic life, and amortization for lessee and lessor.

• Key Calculations include:   - Initial Lease Liability   - Interest Rate Charged   - Amortization Schedule

Further Scenarios (Problems B & C)

• Addressing variations in asset lifespans and accounting treatments under both lessee and lessor perspectives for operating leases.

Hi-Tech Computers Problem

• Lease for server racks by Hi-Tech with specified payments, manufacturing costs, and initial entry requirements.

• Includes steps to compute lease payments and associated journal entries.