INTERMEDIATE

ACCOUNTING
Sixth Canadian Edition
KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER,
YOUNG, WIECEK

Prepared by
Gabriela H. Schneider, CMA; Grant MacEwan College

CHAPTER

21
Leases

Learning Objectives
1. Explain the nature, economic substance,
and advantages of lease transactions.
2. Identify and explain the accounting criteria
and procedures for capitalizing leases by
the lessee.
3. Identify the lessees disclosure
requirements for capital leases.
4. Identify the lessees accounting and
disclosure requirements for an operating
lease.

Learning Objectives
5. Contrast the operating and capitalization
methods of recording leases.
6. Calculate the lease payment required for
the lessor to earn a given return.
7. Identify the classifications of leases for the
lessor.
8. Describe the lessors accounting for direct
financing leases.
9. Describe the lessors accounting for sales-

Learning Objectives
10. Describe the lessors accounting for
operating leases.
11. Identify the lessors disclosure
requirements.
12. Describe the effect of residual values,
guaranteed and unguaranteed, on lease
accounting.
13. Describe the effect of bargain purchase
options on lease accounting.
14. Describe the lessors accounting

Leases
Basics of
Leasing

Accounting by
Lessees

Capitalization
Advantage criteria
s of leasing Accounting for a
capital lease
Conceptual
Capital lease
nature of a method
lease
illustrated
Reporting and
disclosurecapital leases
Accounting for
an operating
lease
Reporting and
disclosureoperating lease
Illustration of

Accounting
by Lessor

Special Illustrations
Accountin of Lease
g Issues Arrangemen

Economics of
leasing
ts
Residual
Classification values
Harmon,
Capitalization Bargain
criteria
Inc.
purchase
Direct
options
Ardens
financing lease Initial
Oven Corp.
Sales-type
direct
lease
costs
Mendotta
Operating
Current
Truck Corp.
leases
versus
Reporting and noncurrent Appleland
disclosure
Unsolved
Computer
Illustration of problems
lessor
disclosures

Leasing: Basics
The lease is a contractual agreement
between the lessor and the lessee
The lease gives the lessee the right to
use specific property
The lease specifies also the duration of
the lease and rental payments
The obligations for taxes, insurance,
and maintenance may be assumed by
the lessor or the lessee

Advantages of Leasing
100 percent financing at a fixed rate
No down payment required
Rate charged is fixed for the term of the lease

Protection from obsolescence

Property can be upgraded

Flexibility
Lease may be structured to meet different needs
(e.g., cash flow)

Less costly financing (lessee); tax

incentives (lessor)
Off-balance sheet financing
Impact on ratios

Lease Classification
Capital Lease
Where the rights and risks of
ownership have effectively been
transferred to the lessee
Accounted for as a purchase by the lessee

Journal Entries:
Lessee
Leased Equipment
Lease Obligation

XXX
XXX

Lessor
Lease Receivable (net)
Equipment

Lease Classification
Operating Lease
Where the rights and risks of ownership
have not been transferred
A rental-only has occured
Journal Entries:
Lessee
Lease Expense
XXX
Cash
XXX

Lessor
Cash
XXX
Rental Revenue

Capital vs. Operating

Lease
Lease
Agreement

Is there a
No
Transfer of
Ownership
or Bargain
Purchase
Option?
Yes

Is Lease Term No
75% of
Economic Life

Yes
Capital Lease

Is Present
Value of
Payments
90% of Fair
Value
Yes
Operating
Lease

No

Capital Lease Criteria

Transfer of ownership
Economic life
PV of payments
If the PV of minimum lease payments is 90%
of the fair value of the asset
minimum lease payments (lessee) defined as:
Minimum rental payments +
Guaranteed residual value +
Penalty for not renewing or extending lease
+
Bargain purchase option

Minimum Lease Payments

Minimum rental payments
Regular payment made to lessor, excluding
executory costs
Executory costs include insurance, maintenance and
tax expenses
If these payments made by the lessor, they are
excluded from the minimum rental payment calculation

Guaranteed residual value

The amount at which the lessor has the right to
require the lessee to purchase the asset; or
The amount the lessee (or 3rd party guarantor)
guarantees that the lessor will realize

Discount Rate
The rate the lessee would have incurred if
they had borrowed the funds to purchase
the asset (incremental borrowing rate)
Under similar term (length)
Similar security (same type of asset)

This rate is not used when

The lessee knows the implicit borrowing rate
lessor used to calculate the lease payment, and
The implicit borrowing rate is less than the
incremental borrowing rate

Accounting for a
Capital Lease
Asset and liability recorded at the lower of:
PV of the minimum lease payments (as defined
above) or
Fair value of the asset at the inception of the lease

Depreciation of the asset is amortized over:

The economic life of the asset if ownership
transfers to lessee at the end of the lease or there
is a bargain purchase option
The term of the lease if title does not transfer or
there is no bargain purchase option

Accounting for a
Capital Lease
Interest expense resulting from the
lease transaction is recorded following
the effective interest method
The discount rate used to establish the
initial PV is used to amortize the lease
discount

Journal entries required to record a

capital lease transaction are as follows:

Accounting for a
Capital Lease
At the inception of the lease
Dr. Asset
Cr.
Lease Liability
To record interest amortization Using the
Dr. Interest Expense
Effective
Interest Method
Cr.
Interest Payable
Using method
To record asset amortization
appropriate to
Dr. Amortization Expense
Cr.
Accumulated Amortizationthe asset
To record the lease payment
Dr. Related Executory Expense (if any)
Dr. Interest Payable
Dr. Lease Liability
Cr.
Cash

Capital Lease - Example

Lease Terms Given:
Term of 5 years, non-cancellable
Annual payments $25,981.62 (due at beginning of
each year)
Fair value of asset $100,000
Economic life = 5 years
Residual value = Zero
Lease payments include $2,000 property taxes
(executory cost)
Lease has no renewal option, and asset reverts to
Lessor at termination of lease
Lessees incremental borrowing rate = 11%
Lessors implicit rate =10% (known to lessee)

Capital Lease - Example

Does this qualify as a capital lease?
Only one of the tests must be met

Is Present
Is there a
Is Lease
Value of
Transfer
Term 75%
No
Payments
of
of Economic
90% of Fair
Ownershi
Life?
Value?
p or
Bargain
Yes
Purchase
PV of payments (n=5, i=10%
Option?
Yes 25,981.62 - 2000.00 =
Capital Lease
23,981.62 * 4.16986 =
$100,000.00

Capital Lease - Example

Entry to record initial lease transaction
Leased Equipment100,000
Lease Liability 100,000
Entry to record initial payment (Jan 1/02)
Property Tax Expense
2,000.00
Lease Liability
23,981.62
Cash25,981.62
As this is a capital lease the following must
also be recorded (at year end or in each reporting
period)
Interest expense
Asset amortization

Capital Lease - Example

Interest amortization (December 31, 2002)
Interest Expense
7,601.84
Interest Payable 7,601.84
(100,000-23,981.62)*10% = 7,601.84
(Interest Payable is debited, and becomes part of all
subsequent lease payments)
Asset amortization (December 31, 2002)
Amortization expense
20,000
Accumulated amortization
20,000
(100,000 ) / 5 years = 20,000)
(There is no transfer of ownership or bargain purchase
option, so the term of the lease is used to amortize the
asset)

Disclosure Requirements
Capital Lease
Gross amount of assets and accumulated
amortization
Depreciation expense may be disclosed, methods
and rate should be disclosed
Lease obligations reported separately from other
liabilities
Current portion of lease obligation
Minimum lease payments in total and for the next
five fiscal years; executory costs and imputed
interest disclosed separately
Interest expense from the lease may be separately
disclosed; or included with other interest expense
May disclose any related contingencies

Accounting by the Lessor

Leases are classified as either:
Operating Lease
Direct financing Lease These are
capital
Sales-type Lease
leases

The determination of a capital or

operating lease depends on answering a
series of questions

Lease Classification Lessor

Lease
Agreement

Does
Lease
meet any
of Lessees
Capital
Lease
criteria?
No

Risk
associated
with
collection
normal?

Remaining
unreimburseable
Yes costs to
Lessor
estimatible
? No

Yes

Does Asset
Fair Value =
Lessors
Book Value?

No

Yes

Direct
Financing
Lease

No

Operating
Lease

Yes

Sales-Type
Lease

Lease Classification Lessor

Both the direct financing lease and the
sales-type lease are capital leases
The difference is whether or not there
exists a manufacturers or dealers profit
The sales-type lease incorporates a
profit hence the final question on the
previous map
A lease may qualify as a capital lease by
the lessee and as an operating lease by

Direct Financing Lease Lessor

Accounting entries are a virtual mirror
image of the capital lease entries for the
lessee
A couple of differences:
The lease payment must first be calculated
The discount rate used to establish the
Receivable is the rate of return of the lessor
Unearned Interest Revenue is credited with
the difference between the Receivable and
the Asset credit

Capital Lease
Example (Lessor)
Step One Calculate the annual lease payment
required to provide the required rate of return
Cost (FMV) $100,000
Less: PV of the Salvage
0
Amount to be Recovered
$100,000

Payments would then be:

$100,000
=
$23,981.62
1.46986 Annuity due factor for n=5, i=10%
Total payments receivable = 5 * 23,981.62
= 119,908.10

Capital Lease
Example (Lessor)
The lease payment receivable are equal
to:
Lease payments (net of executory
costs) + salvage (residual) value
The unearned interest revenue is the
difference between the lease payment
receivable and the asset cost (FMV)
The journal entries are then:

Capital Lease
Example (Lessor)
January 1, 2002
Lease Payments Receivable 119,908.10
Equipment for Lease
100,000.00
Unearned Interest Revenue
19,908.10
January 1, 2002 (first payment)
Cash ($23,981.62+$2,000) 25,981.62
Executory Costs
2,000.00
Lease Payments Receivable
23,981.62
December 31, 2002
Unearned Interest Revenue 7,601.84
Interest Revenue
7,601.84

Sales-Type Lease - Lessor

Entries are the same as for the direct
financing lease, except for:
Entry at the inception of the lease must
record the sale and cost of goods sold
Recall that the sales-type lease includes
a manufacturers/dealers profit margin

Sales-Type Lease
Example
Take the same data as in our
example, except the asset has been
recorded in the Lessors inventory at
a value of $85,000 (FMV=$100,000)
All previous lessor entries remain
the same except for the entry at the
lease inception
Sales and Gross Profit are recorded

Sales-Type Lease
Example
January 1, 2002
Lease Payments Receivable
119,908.10
Sales 100,000.00
Unearned Interest Revenue 19,908.10
Cost of Goods Sold
85,000.00
Inventory 85,000.00
January 1, 2002 (first payment-remains the same)
Cash ($23,981.62+$2,000)
25,981.62
Executory Costs 2,000.00
Lease Payments Receivable
23,981.62
December 31, 2002 (remains the same)
Unearned Interest Revenue
7,601.84
Interest Revenue
7,601.84

Disclosure Requirements Lessor

Disclose the net investment in the
lease (classified as current and noncurrent)
How the investment is calculated for
purposes of income recognition
Finance income amount
Operating Leases
Separate disclosure of the cost and
accumulated depreciation of the property
Amount of rental (lease) income earned

Other Lease Accounting

Issues
Residual Value
Direct Financing Lease: whether guaranteed or
unguaranteed, the residual is included in the lessor
calculations
Sales-Type Lease: with unguaranteed residual value
the Sales Revenue and COGS are reduced by the PV of
that unguaranteed residual value
Residual value is part of Sales Revenue if guaranteed

Bargain Purchase Option

With direct financing and sales-type leases, the
bargain purchase price is included in the net
investment calculations

Direct Costs of Lessor

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