Leases

ACCOUNTING BY THE LESSOR AND LESSEE

A lease is a contract between a lessor (the owner of the property) and a lessee (the user of the
property). Normally the lessee makes periodic payments in exchange for the use of the property.
The lease term can be for any period of time that is acceptable to both parties. The periodic
payments are called rental payments. The obligation for taxes, insurance and maintenance is
specified in the lease contract.

Capital Leases vs. Installment Notes

In the previous chapter we discussed installment notes which are used to purchase equipment and
real property. In the example, Spencer Company purchase real estate by paying $50,000 down
and arranging a 15-year, 8% mortgage (installment note) for the remaining $200,000. A
capitalized lease operates in similar manner.

Example: Spencer Company leases a piece of equipment for five years. The lease meets the
criteria for capitalization. The minimum lease payments are $2,107 per month for five years.
The implicit interest rate is 10% per annum. The following is an amortization schedule for the
first calendar year.

Interest Carrying
Date Cash Paid Expense Principal Value
4/1/03 100,000
4/1/03 2,107 0 2,107 97,893
5/1/03 2,107 816 1,291 96,602
6/1/03 2,107 805 1,302 95,300
7/1/03 2,107 794 1,313 93,987
8/1/03 2,107 783 1,324 92,663
9/1/03 2,107 772 1,335 91,328
10/1/03 2,107 761 1,346 89,982
11/1/03 2,107 750 1,357 88,625
12/1/03 2,107 739 1,368 87,257

Note that the first payment and the origination of the lease are on the same day. Normally a
lease requires that the lessee make one or more lease payments on the signing of the lease and
transfer of the property. Because this is a capitalized lease instead of an installment purchase the
journal entry to record the transaction would be as follows:

ACCOUNT DEBIT CREDIT

Leased equipment 100,000
Lease payable 100,000
To record the acquisition of equipment under a capitalized lease.

The payment made at the signing of the lease would be recorded as follows:

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ACCOUNT DEBIT CREDIT

Lease payable 2,107
Cash 2,107
To record the first payment on April 1, 2003

The payment made on May 1, 2003 would be recorded in the same manner as a payment on an
installment note.

ACCOUNT DEBIT CREDIT

Lease payable 1,291
Interest expense 816
Cash 2,107
To record the second payment on May 1, 2003

Conceptual Nature of a Lease

There are a variety of arguments for expensing lease payments as they are made. There are also
good arguments for capitalizing leased property as if it were purchased and recording a
corresponding debt obligation. The FASB has developed a set of standards that specify if and
when a lease transaction must be capitalized. If the lease transfers substantially all of the
benefits and risks of ownership of the property the FASB requires that the lease be capitalized.

Capital Leases
Leases are accounted for in one of two ways. If the lease contract is noncancelable and transfers
substantially all of the benefits and risks of ownership to the lessee the lease is capitalized. If the
lease does not meet these criteria it is accounted for as an operating lease.

In a capitalized lease the lessee records the leased property as an asset and the lease obligation as
a liability. The amounts are measured based on the present value of the future rental payments.
The lessor records the lease as a sale recording the present value of the future rental payments as
the selling price and recognizing the costs of the property in the income statement.

There are very specific criteria that must be met for a lease to qualify as a capital lease. The
lease must be noncancelable and meet one or more of the following criteria:

1. The lease transfers ownership of the property to the lessee

2. The lease contains a bargain purchase option
3. The lease term is equal to 75% 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% of the fair value of the leased property

Minimum lease payments include the following:

1. Rental payments (excluding executory costs)
2. Bargain purchase option (if any)
3. Guaranteed residual value (if any)
4. Penalty for failure to renew (if any)

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In calculating 90% of the fair value the lessee uses the lesser of:
1. The lessees incremental borrowing rate, or
2. If known the implicit interest rated computed by the lessor

EXERCISE:
Spencer Company leased equipment from Capital Leasing Company. The lease term is 5 years
and requires equal rental payments of $30,000 at the beginning of each year. The equipment has
a fair value at the inception of the lease of $138,000, and estimated useful life of 8 years, and no
residual value. Spencer Company pays all executory costs directly to third parties. Capital
Leasing Company set the annual rental to earn a rate of return of 10%, and this fact is known to
Spencer Company. The lease does not transfer title or contain a bargain purchase option.
Review the criteria for capitalization and determine if Spencer Company should capitalize this
lease. Respond to each of the criteria listed below:

1. Does the lease transfer ownership of the property to the lessee?

Response:

Solution: No, there is no provision for the transfer of ownership.

2. Does the lease contain a bargain purchase option?

Response:

Solution: No, there is no bargain purchase option.

3. Is the term of the lease equal to 75% or more of the economic life of the leased property?
Response:

Solution: No, the term of the lease is not equal to or greater than 75% of the economic life of the
property.

5 Years
= 62.5% < 75%
8 Years

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4. Does the present value of the minimum lease payments (excluding executory costs) equal or
exceed 90% of the fair value of the leased property?
Response:

Solution: Yes, the present value of the minimum lease payments exceeds 90% of the fair value
of the property.

PV of minimum lease payments

Annuity Factor PV
30,000 * 4.16987 = 125,096

Analysis of factor:
PVOA, n=5, i=10% 3.79079
1 plus 10% 1.10000
PVAD, n=5, i=10% 4.16987

90% of the FV
FV 90% Amount
138,000 * 90% = 124,200

PV 90% FV
125,096 > 124,200

Additional Lessor Conditions for Classification as a Capitalized Lease

From the lessors perspective there are two additional conditions that must be met in order for
the lessor to classify the lease as a capital lease.

1. Collectibility of the payments required from the lessee is reasonably predictable

2. No important uncertainties surround the amount of unreimbursed costs yet to be incurred
by the lessor under the lease

Asset and Liability Accounts

If the lease qualifies as a capital lease the lessee records an asset and liability at the lower of:
1. the present value of the minimum lease payments (excluding executory costs) or
2. the fair market value of the leased asset at the inception of the lease

Depreciation
Depreciation is recorded on the leased property based on the depreciation policies of the lessee
company. If the lease transfers ownership or contains a bargain purchase option the depreciation
is allocated over the useful economic life of the leased asset. If the lease does not contain one of
these two provisions depreciation is allocated over the term of the lease.

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The effective interest method is used to allocate between the interest and principal.

OPERATING LEASES

From the lessees perspective

If the above lease did not meet the criteria for capitalization it would be considered an operating
lease. Operating leases are recorded as current expenses as the lease obligation is incurred. The
following would be the journal entry for the initial lease payment under operating lease
accounting.

ACCOUNT DEBIT CREDIT

Property tax expense 1,000
Rent expense 24,000
Cash 25,000
To record the signing and initial payment on the lease on January 1, 2000
From the lessors perspective
If the lease is classified as an operating lease, the rental payments are record as rental revenue in
the periods earned and the underlying property is depreciated in the normal manner based on the
lessors accounting policies. The leased property and accumulated depreciation are reported
separately on the lessors balance sheet.

Example: Using the information provided above, if the lease does not qualify as a capitalized
lease then Spencer Leasing Company will treat the lease as an operating lease. Under these
circumstances the journal entries to record the receipt of rental payments and the annual
depreciation on the leased equipment would be recorded as follows.

ACCOUNT DEBIT CREDIT

Cash 25,000
Rental revenue 25,000
To record receipt of rental payment

Depreciation expense-leased equipment 10,000

Accumulated depreciation-leased equipment 10,000
To record depreciation expense on leased equipment

CAPITALIZED LEASES

From the Lessees Perspective

Spencer Company entered into a lease agreement on January 1, 2000, to lease equipment for 10
years. The lease terms require that Spencer Company pay the lessor $25,000 per year including
executory costs of $1,000. The first payment is due at the signing of the lease. The useful
economic life of the asset is 10 years and there will be no residual value at the end of the lease.
Spencer Company can borrow money at the rate of 14% per annum. The lease is designed to

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give the lessor a 12% return, which is known to the lessee. The first step is to calculate the
present value of the future minimum lease payments.

Present value of minimum lease payments:

Minimum lease payment 24,000
PVAD, n=10, i=12% 6.32825
Present value 151,878

The executory costs are removed to give us the net lease payment. Using Excel we can calculate
the present value of the 10 lease payments. Remember this is an annuity due so the first payment
does not include any interest. Using a 12% discount rate, which is the lesser of the lessees
incremental borrowing rate or the implicit interest rate computed by the lessor is know by the
lessee, the present value of the minimum lease payments is $151,878. This is the amount that we
will capitalize as an asset and liability at the inception of the lease.

The journal entry to capitalize this lease is presented below:

ACCOUNT DEBIT CREDIT

Leased equipment under capital lease 151,878
Obligations under capital lease 151,878
To record the capital lease of equipment
The next step is to prepare a lease amortization schedule so that we will have the appropriate
information to record each of the annual payments.

LEASE EXECUTORY NET LEASE

DATE PAYMENT COSTS LEASE INTEREST PRINCIPLE OBLIGATION
1/1/00 151,878
1/1/00 25,000 1,000 24,000 0 24,000 127,878
1/1/01 25,000 1,000 24,000 15,345 8,655 119,223
1/1/02 25,000 1,000 24,000 14,307 9,693 109,530
1/1/03 25,000 1,000 24,000 13,144 10,856 98,674
1/1/04 25,000 1,000 24,000 11,841 12,159 86,515
1/1/05 25,000 1,000 24,000 10,382 13,618 72,896
1/1/06 25,000 1,000 24,000 8,748 15,252 57,644
1/1/07 25,000 1,000 24,000 6,917 17,083 40,561
1/1/08 25,000 1,000 24,000 4,867 19,133 21,429
1/1/09 25,000 1,000 24,000 2,571 21,429 0

If we assume that the executory costs are for property taxes then the first journal entry to record
the signing of the lease and the payment made on January 1, 2000 is as follows.

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ACCOUNT DEBIT CREDIT

Property tax expense 1,000
Obligations under capital lease 24,000
Cash 25,000
To record the signing and initial payment on the lease
On December 31, 2000 a journal entry need to be prepared to record the depreciation expense for
the first year of use, and the accrued interest on the obligation that will be paid on the first day to
the next year. This journal entry is as follows:

ACCOUNT DEBIT CREDIT

Interest expense 15,345
Depreciation expense-capital leases 15,188
Interest payable 15,345
Accumulated depreciation-capital leases 15,188
To accrue interest on the lease obligation and record depreciation expense for the first year
On January 1, 2001 we record the actual second payment as follows:

ACCOUNT DEBIT CREDIT

Property tax expense 1,000
Interest payable 15,345
Obligations under capital leases 8,655
Cash 25,000
To record the second payment on January 1, 2001
Again, on December 31, 2001 we will need to record depreciation for the second year and accrue
the interest associated with the payment that will be made on the following January. The
December 31, 2001 journal entry is as follows:

ACCOUNT DEBIT CREDIT

Interest expense 14,307
Depreciation expense-capital leases 15,188
Interest payable 14,307
Accumulated depreciation-capital leases 15,188
To accrue interest on the lease obligation and record depreciation expense for the second year
At the end of the lease we will assume that Spencer Company returns the used equipment to the
lessor. The journal entry to record this final transaction is as follows:

ACCOUNT DEBIT CREDIT

Accumulated depreciation-capital leases 151,878
Leased equipment under capital leases 151,878
To record the return of leased equipment on expiration of the lease
From the Lessors Perspective
Leasing is another form of financing. Many manufactures provide leases for high ticket items in
order to stimulate the sale of their products.

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Economics of Leasing
In order to lease as opposed to selling products manufacturers must earn a return on the lease
above and beyond the profit on the sale of the product. The rate of return that the lessor must
earn is called the implicit rate.

CLASSIFICATION OF LEASES BY THE LESSOR

Depending on the circumstances, from the lessors perspective a capital lease may be accounted
for in one of two ways.
1. Direct financing lease
2. Sales-type lease

If at the inception of the lease the lease meets one or more of Group I criteria and both of the
Group II criteria the lease will be classified as either a direct financing lease or a sales-type lease.
The capitalization criteria for a lessor are as follows:
Group I
1. The lease transfers ownership of the property to the lessee
2. The lease contains a bargain purchase option
3. The lease term is equal to 75% 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% of the fair value of the leased property
Group II
3. Collectibility of the payments required from the lessee is reasonably predictable
4. No important uncertainties surround the amount of unreimbursed costs yet to be incurred
by the lessor under the lease

Direct Financing Method

Direct financing leases are those that are arranged through banks or other financial institutions.
The lessor is a financing organization and not the manufacturer. The financial institution is
providing the resources so that the lessee can acquire the property. The form of financing is a
lease as opposed to a debt instrument secured by the property.

There are three pieces of information necessary to record a direct financing lease.
1. Lease Payments Receivable (Gross Investment)
The minimum lease payments plus the unguaranteed residual value accruing to the lessor at
the end of the lease term is recorded as an asset in the general ledger.

The lease payments receivable include:

1. Rental payments (less executory costs paid by the lessor)
2. Bargain purchase options, if any
3. Guaranteed or unguaranteed residual value, if any
4. Penalty for failure to renew, if any

2. Unearned Interest Revenue

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The fair market value of the property (normally the cost of the item to the lessor) less the
lease payments receivable.

3. Cost of the Inventory of Equipment to the Lessor (Net Investment)

The lessors cost of the item is credited to the inventory account at the time the direct
financing lease is executed.

Example: Spencer Leasing Company enters into a contract to lease equipment to Alexander
Company. The equipment is purchased from Sophie Company for $151,878. Assume that the
lease meets the criteria for capitalization. As the lessor Spencer Leasing Company is providing
the financing for Alexander Company and therefore this will be accounted for as a direct
financing lease. The same facts and circumstances will be used to demonstrate the recording of
the lease transactions. The first transaction that must be recorded is the purchase of the
equipment by Spencer Leasing Company. The company will purchase and lease (sell) the
equipment in simultaneous transactions.

ACCOUNT DEBIT CREDIT

Equipment 151,878
Cash 151,878
To record the purchase of equipement to be leased
The present value of the minimum lease payments should equal the fair market value at the
inception of the lease (the cost to the lessor).

Annual lease payment $25,000

Executory costs 1,000
Net lease payment 24,000
Interest rate 12%
Present value $151,878

FV of equipment $151,878

To analyze the information that we will need to book this lease transaction and the periodic
payment the following amortization schedule is provided.

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ANNUAL
LEASE EXECUTORY NET LEASE
DATE PAYMENT COSTS LEASE INTEREST PRINCIPLE OBLIGATION
1/1/00 151,878
1/1/00 25,000 1,000 24,000 0 24,000 127,878
1/1/01 25,000 1,000 24,000 15,345 8,655 119,223
1/1/02 25,000 1,000 24,000 14,307 9,693 109,530
1/1/03 25,000 1,000 24,000 13,144 10,856 98,674
1/1/04 25,000 1,000 24,000 11,841 12,159 86,515
1/1/05 25,000 1,000 24,000 10,382 13,618 72,896
1/1/06 25,000 1,000 24,000 8,748 15,252 57,644
1/1/07 25,000 1,000 24,000 6,917 17,083 40,561
1/1/08 25,000 1,000 24,000 4,867 19,133 21,429
1/1/09 25,000 1,000 24,000 2,571 21,429 0
250,000 10,000 240,000 88,122 151,878

The lease payments receivable include all payments less executory costs for the duration of the
lease. In this example, the lease payments receivable will be $240,000. The unearned interest
revenue is the difference between the lease payments receivable and the fair market value of the
property at the inception of the lease. In this example, the unearned interest is $88,122
($240,000 - $151,878).

At the signing of the lease, on January 1, 2000, we will need to book the lease payments
receivable, remove the equipment from the lessors books and record the unearned interest
revenue. The following journal reflects this transaction for this example.

ACCOUNT DEBIT CREDIT

Lease payments receivable 240,000
Equipment 151,878
Unearned interest revenue 88,122
To record the capitalization of a financing lease with Alexander Company
The first lease payment is recorded at the signing of the lease so there is no interest associated
with this payment. The following is the journal entry to record the signing of the lease and
receipt of the payment on January 1, 2000.

ACCOUNT DEBIT CREDIT

Cash 25,000
Lease payments receivable 24,000
Property tax payable 1,000
To record the signing and initial payment on the lease
At December 31, 2000 the company will accrue the interest earned on the lease contract as
follows:

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ACCOUNT DEBIT CREDIT

Unearned interest revenue 15,345
Interest revenue 15,345
To accrue interest earned through December 31, 2000
To record the second payment we will need to record the receipt of the payment. The
amortization of unearned interest was already recorded in the above journal entry on December
31, 2000. The journal entry would be recorded as follows:

ACCOUNT DEBIT CREDIT

Cash 25,000
Lease payments receivable 24,000
Property tax payable 1,000
To record the payment received on January 1, 2001
At December 31, 2001 the company will again accrue the interest earned during the year on the
lease contract as follows:

ACCOUNT DEBIT CREDIT

Unearned interest revenue 14,307
Interest revenue 14,307
To accrue interest earned through December 31, 2001
Sales-Type Leases
In a sales-type lease there is a manufacturers or dealers gross profit or loss.

There are four pieces of information necessary to record a sales-type lease.

1. Lease Payments Receivable (Gross Investment)
The minimum lease payments plus the unguaranteed residual value accruing to the lessor at
the end of the lease term are recorded as an asset at the inception of the lease.

2. Unearned Interest Revenue

The gross investment less the fair market value of the asset.

3. Sales Price of the Asset

The present value of the minimum lease payments.

4. Cost of Goods Sold

The cost of the asset to the lessor, less the present value of any unguaranteed residual value.

Example: Spencer Manufacturing Company sells and leases equipment to pet supply
distributors. Assume the same facts and circumstances as in the above two examples except that
it cost Spencer Manufacturing Company $110,000 to manufacture the equipment that is going to
be leased to Alexander Company. We will assume that Alexander Company has guaranteed a
residual value at the end of the lease is $5,000.

Under this scenario the selling price of the equipment has changed. The following provides a
calculation of the selling price of the equipment.

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Annual lease payment 25,000

Executory costs 1,000
Net lease payment 24,000
Interest rate 12%
Present value 151,878
Guaranteed residual 5,000
Interest rate 12%
Present value 1,610
Selling price 153,488

With the guaranteed residual the net present value of the entire package is now $153,488. We
can now calculate the rest of the components of the sale-type lease agreement. The following
provides this analysis.

The gross investment includes the ten annual payments and the guaranteed residual.

Lease Payments Receivable

Minimum lease payments 24,000
Number of periods 10
Lease payments receivable 240,000
Guaranteed residual 5,000
Lease payments receivable 245,000

The unearned interest revenue is equal to the gross investment less the present value of the
minimum lease payments and the present value of the guaranteed residual.

Unearned Interest Revenue

Gross investment 245,000
Present value of minimum lease payments (151,878)
Present value of guaranteed residual (1,610)
Unearned interest revenue 91,512

The sales price is the present value of the minimum lease payments plus the present value of the
guaranteed residual.

Sales Price of Equipment

Present value of minimum lease payments 151,878
Present value of guaranteed residual 1,610
Sales price 153,488

The cost of goods sold was given in the question.

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Cost of Goods Sold 110,000

The gross profit is the sales price less the cost of goods sold.

Gross Profit
Sales price 153,488
Cost of goods sold 110,000
Gross profit 43,488

To better visualize the transactions in this sales-type of lease the following is an amortization
schedule prepared for Spencer Leasing Company.

ANNUAL
LEASE EXECUTORY NET LEASE
DATE PAYMENT COSTS LEASE INTEREST PRINCIPAL OBLIGATION
1/1/00 153,488
1/1/00 25,000 1,000 24,000 0 24,000 129,488
1/1/01 25,000 1,000 24,000 15,539 8,461 121,027
1/1/02 25,000 1,000 24,000 14,523 9,477 111,550
1/1/03 25,000 1,000 24,000 13,386 10,614 100,936
1/1/04 25,000 1,000 24,000 12,112 11,888 89,048
1/1/05 25,000 1,000 24,000 10,686 13,314 75,734
1/1/06 25,000 1,000 24,000 9,088 14,912 60,822
1/1/07 25,000 1,000 24,000 7,299 16,701 44,120
1/1/08 25,000 1,000 24,000 5,294 18,706 25,415
1/1/09 25,000 1,000 24,000 3,050 20,950 4,465
12/31/09 5,000 5,000 535 4,465 0
255,000 10,000 245,000 91,512 153,488

With the above computations complete we can now prepare the journal entries to record the lease
transactions. The first journal entry is to record the sales-type lease at inception.

ACCOUNT DEBIT CREDIT

Cost of goods sold 110,000
Lease payments receivable 245,000
Sales revenue 153,488
Unearned interest revenue 91,512
Inventory 110,000
To record the signing of a sales-type lease on January 1, 2000
Along with the signing of the lease the lessee makes the first payment. The following journal
records the receipt of the first lease payment.

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ACCOUNT DEBIT CREDIT

Cash 25,000
Lease payments receivable 24,000
Property tax payable 1,000
To record the payment received on January 1, 2001
On December 31, 2000 the company will prepare the following journal entry to record the
interest earned in 2000 on the lease contract.

ACCOUNT DEBIT CREDIT

Unearned interest revenue 15,539
Interest revenue 15,539
To accrue interest earned through December 31, 2000
On January 1, 2001 Spencer Leasing Company will receive the second lease payment. This
transaction should be recorded as follows.

ACCOUNT DEBIT CREDIT

Cash 25,000
Lease payments receivable 1,000
Property tax payable 24,000
To record the payment received on January 1, 2001
At the end of the term of the lease, on December 31, 2009, Alexander Company will return the
equipment and pay the amount necessary to honor the guarantee. If we assume that on
December 31, 2009 the fair market value of the equipment is $1,000 then Alexander Company
will return the equipment and pay Spencer Leasing Company the difference between the fair
market value of the equipment and the guarantee of $5,000. In this case the cash payment will
be $4,000.

ACCOUNT DEBIT CREDIT

Inventory 25,000
Cash 1,000
Lease payments receivable 24,000
To record the return of the equipment and payment of the guarantee

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