CH 21

Intermediate Accounting
21-1
Prepared by Coby Harmon University of California, Santa Barbara
21 Accounting for Leases
Intermediate Accounting 14th Edition
Kieso, Weygandt, and Warfield

21-2
Learning Objectives
1. 2. 3. 4. 5. 6. 7. 8. 9.
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Explain the nature, economic substance, and advantages of lease transactions. Describe the accounting criteria and procedures for capitalizing leases by the lessee. Contrast the operating and capitalization methods of recording leases. Identify the classifications of leases for the lessor. Describe the lessors accounting for direct-financing leases. Identify special features of lease arrangements that cause unique accounting problems. Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting. Describe the lessors accounting for sales-type leases. List the disclosure requirements for leases.
Accounting for Leases

Special Accounting Problems Residual values Sales-type leases Bargainpurchase option Initial direct costs Current versus noncurrent Disclosure
Leasing Environment Who are players? Advantages of leasing Conceptual nature of a lease
Accounting by Lessee Capitalization criteria Accounting differences Capital lease method Operating method Comparison
Accounting by Lessor Economics of leasing Classification Direct-financing method Operating method
Unresolved problems
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The Leasing Environment

A lease is a contractual agreement between a lessor and a lessee, that gives the lessee the right to use specific property, owned by the lessor, for a specified period of time. Largest group of leased equipment involves:

Information technology Transportation (trucks, aircraft, rail)
Construction
Agriculture
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LO 1 Explain the nature, economic substance, and advantages of lease transactions.

Who Are the Players?
Banks

Independents
Captive Leasing
Caterpillar Financial Services Corp.
Wells Fargo Chase Citigroup
PNC
23%
Ford Motor Credit (Ford)

IBM Global Financing
47%
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Market Share
26%
LO 1

Advantages of Leasing
1. 100% financing at fixed rates.
2. Protection against obsolescence. 3. Flexibility. 4. Less costly financing. 5. Tax advantages.
6. Off-balance-sheet
financing.
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Conceptual Nature of a Lease
Capitalize a lease that transfers substantially all of the
benefits and risks of property ownership, provided the lease is noncancelable. Leases that do not transfer substantially all the benefits and risks of ownership are operating leases.
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Operating Lease
Rent expense Cash xxx xxx
Substance versus Form
Although technically legal title may not pass, the benefits from the use of the property do.
Capital Lease
Leased equipment Lease liability xxx xxx
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Accounting by the Lessee

If the lessee capitalizes a lease, the lessee records an asset and a liability generally equal to the present value of the rental payments.

Records depreciation on the leased asset. Treats the lease payments as consisting of interest and principal.
Journal Entries for Capitalized Lease
Illustration 21-2
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LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

For a capital lease, the FASB has identified four criteria.
1. Lease transfers ownership of the property to the lessee. 2. Lease contains a bargain-purchase option.
3. Lease term is equal to 75 percent or more of the estimated economic life of the leased property.
4. The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90 percent of the fair value of the leased property.
One or more must be met for finance lease accounting.
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Lease Agreement
Leases that DO NOT meet any of the four criteria are accounted for as Operating Leases.
Illustration 21-4
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Capitalization Criteria
Transfer of Ownership Test
Not controversial and easily implemented.
Bargain-Purchase Option Test
At the inception of the lease, the difference between the option price and the expected fair market value must be large enough to make exercise of the option reasonably assured.
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Economic Life Test (75% Test)
Lease term is generally considered to be the fixed, noncancelable term of the lease.
Bargain-renewal option can extend this period.

At the inception 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 assured.
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Illustration: Home Depot leases Dell PCs for two years at a rental of $100 per month per computer and subsequently can lease them for $10 per month per computer for another two years. The lease clearly offers a bargain-renewal option; the lease term is considered to be four years.
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Recovery of Investment Test (90% Test)
Minimum Lease Payments:

Minimum rental payment Guaranteed residual value Penalty for failure to renew or extend the lease Bargain-purchase option
Executory Costs:

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Insurance
Maintenance Taxes
Exclude from PV of Minimum Lease Payment Calculation

LO 2

Discount Rate
Lessee computes the present value of the minimum lease payments using its incremental borrowing rate, with one
exception.
If the lessee knows the implicit interest rate computed by the lessor and it is less than the lessees incremental borrowing rate, then lessee must use the lessors rate.
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Asset and Liability Accounted for Differently
Asset and Liability Recorded at the lower of:
1. present value of the minimum lease payments (excluding executory costs) or
2. fair-market value of the leased asset.
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Depreciation Period
If lease transfers ownership, depreciate asset over the economic life of the asset.
If lease does not transfer ownership, depreciate over
the term of the lease.
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Effective-Interest Method
Used to allocate each lease payment between principal and interest.
Depreciation Concept
Depreciation and the discharge of the obligation are
independent accounting processes.
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E21-1: On January 1, 2012, Adams Corporation signed a 5-year noncancelable lease for a machine. The terms of the lease called for Adams to make annual payments of $9,968 at the beginning of each year, starting January 1, 2012. The machine has an estimated useful life of 6 years and a $5,000 unguaranteed residual value. Adams uses the straight-line method of depreciation for all of its plant assets. Adamss incremental borrowing rate is 10%, and the lessors implicit rate is unknown. Instructions (a) What type of lease is this? Explain. (b) Compute the present value of the minimum lease payments. (c) Prepare all necessary journal entries for Adams for this lease through January 1, 2013.
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LO 2

E21-1: What type of lease is this? Explain. Capitalization Criteria:
1. 2. 3.
Capital Lease, #3
Transfer of ownership Bargain purchase option Lease term = 75% of economic life of leased property Present value of minimum lease payments => 90% of FMV of property
NO NO
Lease term Economic life 5 yrs. 6 yrs. 83.3%
YES
4.
FMV of leased property is unknown.
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E21-1: Compute present value of the minimum lease payments. Payment Present value factor (i=10%,n=5) PV of minimum lease payments 1/1/12 Journal Entries: Leased Machine (under capital leases) Lease Liability Lease Liability 9,968 41,565 41,565 $ 9,968 4.16986 $41,565
Cash
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9,968

E21-1: Lease Amortization Schedule
10% Interest Expense
Date 1/1/12 1/1/12 12/31/12 12/31/13 12/31/14 12/31/15
Lease Payment
Reduction in Liability $
Lease Liability 41,565 31,597 24,789 17,300 9,062 0
9,968 9,968 9,968 9,968 9,968 3,160 2,479 1,730 906
9,968 6,808 7,489 8,238 9,062
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E21-1: Journal entries for Adams through Jan. 1, 2013.
12/31/12
Depreciation Expense Accumulated Depreciation
($41,565 5 = $8,313)
8,313 8,313
Interest Expense Interest Payable

($41,565 $9,968) X .10]
3,160 3,160
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E21-1: Journal entries for Adams through Jan. 1, 2012.
1/1/13
Lease Liability Interest Payable 6,808 3,160
Cash
9,968
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Operating Method
The lessee assigns rent to the periods benefiting from the use of
the asset and ignores, in the accounting, any commitments to make future payments. Illustration: Assume Adams accounts for it as an operating lease. Adams records this payment on January 1, 2012, as follows. Rent Expense Cash 9,968 9,968
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LO 3 Contrast the operating and capitalization methods of recording leases.

E21-1: Comparison of Capital Lease with Operating Lease
E21-1 Finance Lease Depreciation Interest Expense Expense Total $ 8,313 8,313 8,313 8,313 8,313 $ 41,565 $ 8,275 $ $ 3,160 2,479 1,730 906 $ 11,473 10,792 10,043 9,219 8,313 49,840 $ Operating Lease Expense $ 9,968 9,968 9,968 9,968 9,968 49,840
Date 2012 2013 2014 2015 2016
Diff. $ 1,505 824 75 (749) (1,655) 0
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LO 3 Contrast the operating and capitalization methods of recording leases.
Special Accounting Problems

Residual Values
Meaning of Residual Value - Estimated fair value of the
leased asset at the end of the lease term. Guaranteed Residual Value Lessee agrees to make up
any deficiency below a stated amount that the lessor

realizes in residual value at the end of the lease term.
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LO 6 Identify special features of lease arrangements that cause unique accounting problems.

Illustration (Guaranteed Residual Value Lessee Accounting):
Assume that Sterling depreciated the leased asset down to its residual value of $5,000 but that the fair market value of the residual value at December 31, 2016, was $3,000. Sterling would make the following journal entry. Loss on Capital Lease 2,000.00
Interest Expense (or Interest Payable)

Lease Liability Accumulated Depreciation Leased Equipment (under capital leases)
454.76
4,545.24 95,000.00 100,000.00
Cash
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2,000.00
LO 7 Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting.

Illustration (Unguaranteed Residual Value Lessee Accounting):
Assume the same facts as those above except that the $5,000 residual value is unguaranteed instead of guaranteed. Caterpillar would compute the amount of the lease payments as follows:
Illustration 21-20
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Computation of Lease Amortization Schedule
Illustration 21-21
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At the end of the lease term, before Sterling transfers the asset to Caterpillar, the lease asset and liability accounts have the following balances.
Illustration 21-22
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Comparative Entries, Lessee Company
Illustration 21-23
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Bargain Purchase Option (Lessee)
Present value of the minimum lease payments must include the present value of the option. Only difference between the accounting treatment for a bargain-purchase option and a guaranteed residual value of identical amounts is in the computation of the annual depreciation.
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LO 8 Describe the lessors accounting for sales-type leases.

Current versus Noncurrent
GAAP does not indicate how to measure the current and noncurrent amounts.
For both the annuity-due and the ordinary-annuity situations report the reduction of principal for the next period as a current liability/current asset.
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LO 8 Describe the lessors accounting for sales-type leases.

Disclosing Lease Data
For lessees:
1. 2. General description of material leasing arrangements. Reconciliation between the total of future minimum lease payments at the end of the reporting period and their present value. 3. Total of future minimum lease payments at the end of the reporting period, and their present value for periods (1) not later than one year, (2) later than one year and not later than five years, and (3) later than five years.
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LO 9 List the disclosure requirements for leases.

Disclosing Lease Data
1. 2.
General description of the nature of leasing arrangements. The nature, timing, and amount of cash inflows and outflows associated with leases, including payments to be paid or
received for each of the five succeeding years.

3.
The amount of lease revenues and expenses reported in the income statement each period.
4.
Description and amounts of leased assets by major balance sheet classification and related liabilities.
5.
Amounts receivable and unearned revenues under lease agreements.
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LO 9 List the disclosure requirements for leases.
APPENDIX
Illustration 21A-1 Illustrative Lease Situations, Lessors
21A
EXAMPLES OF LEASE ARRANGEMENTS
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LO 10
APPENDIX
21A
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LO 10
APPENDIX
21A
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LO 10
APPENDIX
21A
Illustration 21A-3
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LO 10 Understand and apply lease accounting concepts to various lease arrangements.
APPENDIX
21A
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LO 10
APPENDIX
21A
Illustration 21A-4
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APPENDIX
21A
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APPENDIX
21A
Illustration 21A-5
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APPENDIX
21B
SALE-LEASEBACKS
Lessee
If the lease meets one of the four criteria for treatment as a capital lease, the seller-lessee should
Account for the transaction as a sale and the lease as a capital lease. Defer any profit or loss it experiences from the sale of the assets that are leased back under a capital lease. Amortize profit over the lease term .
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LO 11 Describe the lessees accounting for sale-leaseback transactions.
APPENDIX
21B
SALE-LEASEBACKS
Lessee
If none of the capital lease criteria are satisfied, the sellerlessee accounts for the transaction as a sale and the lease as
an operating lease.
Lessee defers such profit or loss and amortizes it in proportion to the rental payments over the period when it expects to use the assets.
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LO 11 Describe the lessees accounting for sale-leaseback transactions.
APPENDIX
21B
SALE-LEASEBACKS
Illustration 21B-1
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RELEVANT FACTS
Both GAAP and IFRS share the same objective of recording leases by lessees and lessors according to their economic substancethat is, according to the definitions of assets and liabilities. GAAP for leases uses bright-line criteria to determine if a lease arrangement transfers the risks and rewards of ownership; IFRS is more general in its provisions. One difference in IFRS and GAAP is that finance leases are referred to as capital leases in GAAP. Under IFRS, lessees and lessors use the same general lease capitalization criteria. GAAP has additional lessor criteria that payments are collectible and there are no additional costs associated with a lease.
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RELEVANT FACTS
IFRS requires that lessees use the implicit rate to record a lease, unless it is impractical to determine the lessors implicit rate. GAAP requires use of the incremental rate, unless the implicit rate is known by the lessee and the implicit rate is lower than the incremental rate. Under GAAP, extensive disclosure of future noncancelable lease payments is required for each of the next five years and the years thereafter. Although some international companies (e.g., Nokia) provide a year-by-year breakout of payments due in years 1 through 5, IFRS does not require it.
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RELEVANT FACTS
The FASB standard for leases was originally issued in 1976. The standard (SFAS No. 13) has been the subject of more than 30 interpretations since its issuance. The IFRS leasing standard is IAS 17, first issued in 1982. This standard is the subject of only three interpretations. One reason for this small number of interpretations is that IFRS does not specifically address a number of leasing transactions that are covered by GAAP. Examples include lease agreements for natural resources, sale-leasebacks, real estate leases, and leveraged leases.
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IFRS SELF-TEST QUESTION

Which of the following is not a criterion for a lease to be recorded as a finance lease?
a. There is transfer of ownership. b. The lease is cancelable. c. The lease term is for the major part of the economic life of the asset.
d. There is a bargain-purchase option.
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Under IFRS, in computing the present value of the minimum lease payments, the lessee should:
a. use its incremental borrowing rate in all cases. b. use either its incremental borrowing rate or the implicit rate of the lessor, whichever is higher, assuming that the implicit rate is known to the lessee. c. use either its incremental borrowing rate or the implicit rate of the lessor, whichever is lower, assuming that the implicit rate is known to the lessee.
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d. use the implicit rate of the lessor, unless it is impracticable to determine the implicit rate.

A lease that involves a manufacturers or dealers profit is a (an):
a. direct financing lease. b. finance lease. c. operating lease.
d. sales-type lease.
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Copyright
Copyright 2012 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in

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may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
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CH 21

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Intermediate Accounting

Prepared by Coby Harmon University of California, Santa Barbara

21 Accounting for Leases

Intermediate Accounting 14th Edition

Kieso, Weygandt, and Warfield

Accounting for Leases

Accounting by Lessor Economics of leasing Classification Direct-financing method Operating method

The Leasing Environment

Information technology Transportation (trucks, aircraft, rail)

LO 1 Explain the nature, economic substance, and advantages of lease transactions.

The Leasing Environment

Wells Fargo Chase Citigroup

Ford Motor Credit (Ford)

The Leasing Environment

The Leasing Environment

LO 1 Explain the nature, economic substance, and advantages of lease transactions.

The Leasing Environment

Substance versus Form

LO 1 Explain the nature, economic substance, and advantages of lease transactions.

Accounting by the Lessee

Journal Entries for Capitalized Lease

Accounting by the Lessee

Accounting by the Lessee

Accounting by the Lessee

Not controversial and easily implemented.

Bargain-Purchase Option Test

Accounting by the Lessee

Bargain-renewal option can extend this period.

enough to make exercise of the option to renew

Accounting by the Lessee

Accounting by the Lessee

Exclude from PV of Minimum Lease Payment Calculation

Accounting by the Lessee

Accounting by the Lessee

2. fair-market value of the leased asset.

Accounting by the Lessee

If lease does not transfer ownership, depreciate over

the term of the lease.

Accounting by the Lessee

Used to allocate each lease payment between principal and interest.

Depreciation and the discharge of the obligation are

independent accounting processes.

Accounting by the Lessee

Accounting by the Lessee

FMV of leased property is unknown.

Accounting by the Lessee

Accounting by the Lessee

Date 1/1/12 1/1/12 12/31/12 12/31/13 12/31/14 12/31/15

Lease Liability 41,565 31,597 24,789 17,300 9,062 0

9,968 9,968 9,968 9,968 9,968 3,160 2,479 1,730 906

9,968 6,808 7,489 8,238 9,062

Accounting by the Lessee

Interest Expense Interest Payable

Accounting by the Lessee

Accounting by the Lessee

LO 3 Contrast the operating and capitalization methods of recording leases.

Accounting by the Lessee

Date 2012 2013 2014 2015 2016

Diff. $ 1,505 824 75 (749) (1,655) 0

LO 3 Contrast the operating and capitalization methods of recording leases.

Special Accounting Problems

any deficiency below a stated amount that the lessor

Special Accounting Problems