Leases

Dr. Derek K. Chan

HKU

1
Outline

1. Leases - Definition and Overview

2. Nature of Leases
3. Lease Classification Criteria
4. Accounting for Operating Leases
5. Accounting for Finance Leases
6. Initial Direct Costs

Leases 2
1. Leases Definition and Overview
Companies seeking to obtain the longer-term right to use
depreciable assets will typically enter into one of the
following three types of extended agreements where
repayments are made by installments:
1. Direct credit/installment sales - legal title transferred
to buyer at the point of sale/delivery.
2. Hire purchase - a lease contract which transfers legal
title from seller (lessor) to buyer (lessee) after the last
installment OR if buyer exercises his/her purchase
option.
3. A lease contract with or without any purchase option
to the buyer.
Leases 3
1. Leases Definition and Overview

2 and 3 above are examples of lease contracts under which

the owner of a property, the lessor, transfers the right to
use the property to a lessee for a specific period in
exchange for stipulated cash payments. The lessor retains
legal title of the property during the lease period.

Leases 4
1. Leases Definition and Overview
Advantages of lease contracts
From the lessees point of view:
No or low down payment
Avoid risk of ownership
Technological obsolescence
Physical deterioration
Changing economic conditions
From the lessors point of view:
Increased sales
Ongoing business relationship with the lessee
Residual value retained

Leases 5
1. Leases Definition and Overview

Main issue:
Despite the lack of legal ownership by the lessee during
the period of a lease contract, in practice the lessee has
acquired the rights to substantially use up an asset.
The accounting issue, then, is whether or not to treat the
lease as an asset purchase and capitalize or to treat it as
a pure rental.

Leases 6
1. Leases Definition and Overview
The answer hinges on the economic reality of the lease
substance over form.
The key is: "Has the lessor transferred substantially all
the benefits and risks of ownership?
1. Does the lease directly transfer ownership?
2. If the answer to the first question is negative, does the
lease give the lessee the opportunity to purchase the
asset at a really low price (a bargain purchase option)?
3. Does the lease term substantially cover the economic
life of the asset?
4. Is the lessor approximately receiving the fair market
value (FMV) of the asset?

Leases 7
1. Leases Definition and Overview
Lessee Lessor
If the lease is Records an asset and Has sold an asset
noncancelable corresponding Has a Receivable for
and the depreciation future lease payments
answer is YES Has a liability to make Receives Interest
to any one of future lease payments Income
the above Incurs Interest Expense
If NO No asset is recorded No Sale is recorded
Incurs Rent Expense Receives Rent
Income

Leases 8
1. Leases Definition and Overview
Two types of leases are consistent with this decision:

1. Operating Leases:
The lessee has NOT substantially assumed the
benefits and risks of ownership.
The lease is treated as a rental.
The rental payments represent rent revenue (expense)
to the lessor (lessee) over the lease term.
The rented asset remains on the lessors books and is
depreciated over time.

Leases 9
1. Leases Definition and Overview
2. Finance (Capital) Leases:
The lessee has substantially assumed the benefits and risks
of ownership. (The lessee has effective ownership of the
leased property.)
The lease is treated as an asset purchase, financed over time.
The lessee (lessor) records an acquisition (sale) of an asset
and its related liability (receivable) at the present value of
the lease payments.
Lease payments by the lessee are divided into the payment
of interest and principal. Cash flow from operations is
reduced by the interest payment and cash flow from
financing is reduced by the principal payment.
The depreciation period is the lease period or the life of the
asset depends on whether the lease transfers ownership or
has a bargain purchase option.

Leases 10
1. Leases Definition and Overview
With respect to the lessor there are two types of
finance leases:
1. Direct Financing Lease:
Lessor is a bank or financing company.
Present value of the lease payments is equal to
the lessor cost of property no profit from
sales.
The only revenue generated by this type of lease
is interest revenue.
2. Sales-type Lease:
Lessor is a dealer or manufacturer.
The revenue generated is divided into (a) interest
earned and (b) sales price minus cost of goods
sold (i.e., profit from sales).
Leases 11
1. Leases Definition and Overview
Incentives for structuring a lease as an operating lease are:
Operating lease avoids recognition of the debt on the lessees
balance sheet decreases leverage ratios.
An operating lease is an example of off-balance-sheet financing
and is advantageous to the lessee:
If management compensation is sensitive to returns on
invested capital (ROA = Net income / Average Total Assets).
If the lessee has bond covenants relating to financial policies
(e.g., a maximum debt-to-equity ratio).

Leases 12
1. Leases Definition and Overview

It can be shown by a simple example that capitalization of

leases (under finance lease) always serves to harm the
appearance of the lessees solvency.

Example: Lease Capitalization Increases Debt-to-Equity Ratio

Asset = Liability + Equity
Prior position 3 1 2
Assumed capitalization +1 +1 0
Post position 4 2 2

Leases 13
1. Leases Definition and Overview
The prior debt-to-equity ratio is whereas the post debt-
to-equity ratio is 1. Except for a firm with zero equity (i.e.,
100% debt financed), capitalization will always add
proportionately more debt to the balance sheet.
For the lessor (of a direct financing lease), on the other
hand, capitalization does not mathematically impact the
capital structure; indeed, it has the effect of replacing an
illiquid tangible asset for a noncancellable (less risky)
claim to future cash flows.
Operating lease is an example of off-balance sheet
financing (i.e., an attempt to borrow monies in such a way
that the obligations are not recorded on the balance sheet).

Leases 14
1. Leases Definition and Overview
Incentives for structuring a lease as a finance lease are:
The lessor (of a sales-type lease) will have earlier
recognition of revenue and income by reporting a
completed sale even though the substance of the
transaction is similar to an installment sale.
The lessor will have higher profitability and asset
turnover (Net Sales / Average Total Assets) ratios.

Leases 15
1. Leases Definition and Overview
HKAS 17 Leases (issued December 2004, revised May 2009),
which supersedes HKSSAP 14 Leases (issued October 1987;
revised February 2000), has required accountants to make a
classification of all lease contracts of an entity into either finance
leases or operating leases.
It requires that a finance lease should be capitalized by the lessee -
that is, accounted for as the purchase of rights to the use of the
asset with simultaneous recognition of the obligation to make
future payments. A hire purchase is normally accounted for in a
similar manner.
Under an operating lease, only the rental will be taken into account
by a lessee.
Compliance with this statement ensures compliance with
International Accounting Standard IAS 17 Leases.
ADDITIONAL READINGS: HKAS 17 "Leases".
Leases 16
2. Nature of leases
A lease is a contract specifying the terms under which the
owner of property, the lessor, transfers the right to use the
property to a lessee.
Terms include:
the periods of the lease and lease payments
cancellability of the lease and if such requires mutual
agreement and compensation
whether the lessee or lessor is responsible for executory
costs (e.g., insurance, maintenance, ..)
conditions applicable at the end of the lease period,
including purchase rights by the lessee and residual
guarantees
Leases 17
2. Nature of leases
i. Lease Term
The lease term includes the noncancellable lease period,
plus any periods covered by bargain renewal options that
include favorable lease terms (e.g., low lease payments)
that make it likely that the lessee will renew the lease.

Leases 18
Contract A
Cash
$1,000 $1,000 $1,000 $1,000 $1,000
Flow*

Time 0 1 2 3 4 5 6 7
Lease Term = 5 years
MLP =?

* Lease payments are usually paid in advance.

Contract B
Cash
$1,000 $1,000 $1,000 $1,000 $1,000 $100 $100
Flow

Time 0 1 2 3 4 5 6 7

Lease Term = 5 or 7 years? Bargain Renewal Option

MLP =?

Leases 19
2. Nature of leases
ii. Cancellation Provisions
Some leases are noncancellable, meaning that these lease
contracts are cancellable only upon the outcome of some
remote contingency or that the cancellation provisions and
penalties of these leases are so costly to the lessee that, in
all likelihood, cancellation will not occur.
All cancellable leases are accounted for as operating
leases; some, but not all, noncancellable leases are
accounted for as finance leases.

Leases 20
2. Nature of leases
iii. Bargain Purchase Option (BPO)
Leases often include a provision giving the lessee the right
to purchase leased property at some future date.
If the specified purchase option price is expected to be
considerably less than the fair market value at the date the
purchase option may be exercised, then the option is called
a bargain purchase option.
By definition, the exercise of the option is reasonably
assured because the price is so low.
The length of the lease term is limited to the time up to
when a BPO becomes exercisable.

Leases 21
Contract C
Cash
$1,000 $1,000 $1,000 $1,000 $1,000
Flow

Time 0 1 2 3 4 5 6 7

Lease Term = 3 or 5 years? BPO = 3,000 < 5,000 = FMV

MLP =?

Leases 22
2. Nature of leases
iv. Residual Value
The estimated FMV of the leased asset at the end of the
lease term. It can be guaranteed or unguaranteed by the
lessee or a third-party guarantor (e.g., parent company or
insurance company).
Guaranteed residual value (GRV): If the market value
at the end of the lease term falls below the GRV, the
lessee or the third-party guarantor must pay the
difference.
Unguaranteed residual value (UGRV): The actual
amount of the residual value is unknown until the end
of the lease term; however, it must be estimated (by the
lessor in order to determine the implicit rate of the lease
and the depreciation) at the inception of the lease.
Leases 23
Contract D
Cash
$1,000 $1,000 $1,000 $1,000 $1,000
Flow

Time 0 1 2 3 4 5 6 7

Lease Term = 5 years

GRV=$2,500
MLP =?

Leases 24
2. Nature of leases
v. Minimum Lease Payments (MLP):
MLP are rental payments required over the lease term plus any
amount to be paid for the residual value either through a
bargain purchase option or a guarantee of the residual value.
The UGRV or GRV by third-party guarantor is not included in
the lessees MLP.
Executory costs (such as insurance, maintenance, etc.) are
NOT included as part of MLP. Instead, if lessee pays these
they will be charged periodically as LEASE EXPENSES. If
lessor pays these they need to be backed off the lease payment
(assume that reimbursement is built into lease payment).
Leases 25
Example 1:
Daqing leased an equipment from No. 1 Leasing with the following
terms:
Lease period: 10 years, beginning January 1, 2014. Noncancellable.
Rental amount: $1,000 per year, payable annually in advance.
Estimated life: 10 years.
Expected residual value at the end of 10 years: 0.
Fair market value (FMV) of the equipment is $6,759.
Since the lessor sets the price (i.e., lease payment), the implicit rate of
the lease must be: 10%. See below:
Present value (PV) of the payments = FMV of the machine if implicit
interest rate is 10%:
1,000 + 1,000 PV ordinary annuity for 9 years with interest rate
10% p.a. (P10%,9 ) = 1,000 + 1,000 5.759 = 6,759 (= FMV).

Leases 26
Example 1
Cash
$1,000 $1,000 $1,000 $1,000
Flow

Time 0 1 2 9 10
E(RV) =$0
FMV = $6,759

Leases 27
3. Lease Classification Criteria

A lease is an operating lease if it is cancellable.

If a lease is noncancellable, then the four general lease
classification criteria, applicable to both lessors and
lessees, are:
1. Title transfer?
2. Bargain purchase option?
3. Lease term = major part of Useful life? (US rule:
75%)
4. PV of minimum lease payments substantially all
of FMV of equipment? (US rule: 90%)
Leases 28
3. Lease Classification Criteria
If the answer to ANY of the above questions is yes, the
lessee classifies the lease as a finance lease.
Remarks:
1. For a finance lease that satisfies either (1) or (2) above, the
leased asset is depreciated over the economic life of the asset.
2. For a finance lease that satisfies either (3) or (4) above but not
(1) or (2), the leased asset is depreciated over the lease term.
3. In HK, there is a fifth condition for a finance lease:
(5) The leased assets are of such a specialized nature that only
the lessee can use them without major modifications.

Leases 29
3. Lease Classification Criteria
For the lessor, the lease is a finance lease if, in addition to
one of the these criteria, both of the following conditions
are met:
Collection of the minimum lease payments is
reasonably assured. (Revenue is realizable.)
The lessor has substantially completed its obligations to
the lessee as of the date of the lease signing; no
significant work remains to be done. If there are works
to be done, the cost must be reimbursable. (Revenue is
earned.)

These criteria are in IAS No. 17 and HKAS 17.

Leases 30
3. Lease Classification Criteria
When do minimum lease payments (MLP) matter?
1. Classification: When determining if a lease is operating or
finance. According to HKAS 17 para 10(d), a lease is a
finance lease if:
"at the inception of the lease the present value of the
minimum lease payments amounts to at least
substantially all of the fair value of the leased asset;
and ..."
US GAAP are more specific:
"the present value of the minimum lease payments
(excluding executory costs) equals or exceeds 90% of
the fair market value of the leased property."
Leases 31
3. Lease Classification Criteria
2. Valuation Lessee: If a lease is determined to be finance,
at the inception of the lease the lessee records an asset
and a liability at the lower of :
The present value of the MLP (excluding executory
costs).
The FMV of the leased asset.

3. Valuation Lessor: If a lease is determined to be finance,

the lessor records a lease payment receivable equal to
his/her net investment in the lease. The net investment is
equal to the present value of the MLP plus the present
value of UGRV.
Leases 32
3. Lease Classification Criteria
Remarks:
1. If the lessor and the lessee use the same interest rate to
calculate present values, then
For GRV, lessors lease payments receivable = lessees lease
liability.
For UGRV, lessors lease payments receivable = lessees lease
liability + PV of UGRV. (Recall: UGRV is not included in MLP)
2. But discount rates may not be the same!
For the lessor, we use the implicit interest rate (the rate that
equates the present value of the lease payments and residual
value to the FMV of the property) to calculate the present value
of MLP.
For the lessee, the interest rate we use when calculating the
present value of MLP is the lower of:
The lessees incremental borrowing rate.
The lessors implicit rate if it is known.

Leases 33
3. Lease Classification Criteria

Why the lower rate?

To prevent the lessee from using a higher rate and lowering
the present value (thus avoiding the 90% test).

Leases 34
3. Lease Classification Criteria
Impacts of bargain purchase option (BPO):
1. Classification: Will result in the lease being a finance
lease.
2. Valuation: BPO is included in the definition of MLP
and therefore
With respect to the lessee it impacts the asset value
capitalized and the lease obligation recorded.
From the lessor standpoint it impacts the lease
payment receivable (= PV of MLP).
3. Depreciation: The depreciable life of the asset will be
its economic life (vs. the lease term) since ownership
is assumed to stay with the lessee.
Leases 35
3. Lease Classification Criteria

Where does residual value (RV) come into play?

The residual value risk for unguaranteed residual values
(UGRV) is borne by the lessor.
The residual value risk for guaranteed residual values (GRV)
is borne by the lessee or a third party guarantor.

Leases 36
 Residual Values Lessees Perspective:
Guaranteed RV Unguaranteed RV
1. MLP include GRV* 1. UGRV does not impact MLP
GRV is like an additional lease payment Therefore the UGRV does
that will be paid at the end of the lease not impact asset value or
term, and is included in PV of MLP. lease obligation value.
Therefore the GRV impacts the amount
recorded as an asset and as a liability.
(Lease liability = PV of MLP)
2. When calculating depreciation, however, the 2. The UGRV is not included in
GRV is subtracted from the asset cost. the asset value so no adjustment
Depreciation is taken down to the GRV is necessary. The asset is fully
(Depreciable cost = PV of MLP - GRV) depreciated. (Depreciable cost =
PV of MLP)
3. If at the end of the lease term the FMV of the 3. No loss is recorded, as the
property is less than the GRV, the lessee will lessee has not guaranteed
have to record a loss (because the lessee has anything.
guaranteed it).
* When the RV is guaranteed by a third-party guarantor, it is not included in the lessees MLP.
Leases 37
Residual Values Lessors Perspective
Direct Financing: Guaranteed & Unguaranteed Residual Values
The lessor works on the assumption that the RV will be realized at the
end of the lease term whether or not it is guaranteed.

The lessor records an asset representing the lease payment receivable.

This receivable is calculated as the PV of MLP plus the PV of any
UGRV. (Receivables = PV of MLP + PV of UGRV)

Because GRV is already included in the definition of MLP; the lease

receivable will include RV whether Guaranteed or Unguaranteed.

Leases 38
Residual Values - Lessors Perspective (Contd)
Sales Type: Guaranteed RV
All information included under the direct financing section also pertains
to sales type leases whether GRV or UGRV.
But in addition:
The lessor can include the PV of the GRV as a part of sales revenue.
This is appropriate because there is no uncertainty surrounding the
realization of the GRV.
Sales revenues = PV of MLP;
COGS = Inventory cost
Because the RV is guaranteed the lessor will not lose money if it
declines in value. No entries are required for changes in RV
amounts during the lease term.

Leases 39
Residual Values Lessors Perspective (Contd)
Sales Type: Unguaranteed RV
All information included under the direct financing section also pertains to Sales
type leases whether GRV or UGRV.
But in addition:
The lessor CANNOT include the PV of the UGRV as a part of sales revenue.
Because it is unguaranteed, there exists uncertainty as to its realization.
Revenue recognition has not occurred.
Because we cannot match expense (in this case COGS) against unrecognized
revenue, the COGS must be reduced by the PV of the UGRV.
Sales revenues = PV of MLP; COGS = Inventory cost PV of UGRV;
Receivables = Sales + PV of UGRV
If the actual RV declines during the lease term, because it is unguaranteed the
lessor is going to lose money (he based his lease payments on the higher
number). A loss should be recorded immediately. Gains are not recorded (i.e.,
gain contingency). Leases 40
4. Accounting for Operating Leases
According to HKAS 17, the lessor should account for an
operating lease by capitalizing and depreciating the leased
asset. The lessee, on the other hand, will only take the
rental expense into account.

Lessee Lessor
The rented asset as well as any long- The rented asset stays on the
term liability to make future lessors books and is depreciated in
payments is ignored. the normal manner.
100% of the rent payments are 100% of the rent payments are
expensed as paid. included in income as received.
Appropriate accruals are made if the accounting period ends between cash
payment dates.

Leases 41
Example 2
Daqing leased an equipment from No. 1 Leasing with the
following terms:
Lease period: 5 years, beginning January 1, 2014.
Noncancellable.
Rental amount: $1,000 per year, payable annually in
advance.
Estimated life: 10 years.
FMV of the equipment is $6,759.
The lessees incremental borrowing rate is 12%.
The implicit rate of the lease (of the lessor) is 10%.
No bargain purchase option. Residual value is not
guaranteed.
Leases 42
Example 2 (Contd)
Why is this an operating lease? Show your work.

Who carries the leased equipment in the balance sheet?

Does the lessee need to show any debt of future rent

payments?
Leases 43
 In case with varying lease payments, periodic expense
should be recognized on a straight-line basis. That is, we
should smooth the lease payments.
Example 3 (Lease with varying lease payments):
Continued with our previous example, except that we now
assume that the lessor, No. 1 Leasing, agrees to a rent-free
period for the first year as an incentive for the lessee, Daqing,
to enter into the lease. The lease period is still 5 years, at a
fixed rate of $1,250 per annum for years 2014 through 2017.

Total lease payments: $1,250 4 years = $5,000.

Total lease payments should be apportioned over 5 years on a

straight-line basis. The annual rental expense for the lessee is
$5,000/5 = $1,000. Leases 44
 Example 3 (Lease with varying lease payments)
Cash
$0 $1,250 $1,250 $1,250 $1,250
Flow

Time 0 1 2 3 4 5

Lease
$1,000 $1,000 $1,000 $1,000 $1,000
Expense

Time 0 1 2 3 4 5

Leases 45
Example 3 (Contd)
Differences between the actual payments and the debit to expense
would be reported as Rent Payable or Prepaid Rent. The required
entries for the lessee in the first year would be:
Rent Expense 1,000
Rent Payable (a long-term liability)* 1,000

The entries for each of the last four years would be:
Rent Expense 1,000
Rent Payable 250
Cash 1,250
* The portion of Rent Payable due in the subsequent year would
be classified as a current liability.
Leases 46
5. Accounting for Finance Leases

HKAS 17 requires that a finance lease should be

capitalized by the lessee - that is, accounted for as the
purchase of rights to the use of the asset with simultaneous
recognition of the obligation to make future payments.
The lessor, on the other hand, should account for a finance
lease on a basis similar to that for a loan that earns interest
revenue, rather than as a fixed asset subject to depreciation.

Leases 47
5. Accounting for Finance Leases
Lessee
(Direct Financing or Sales Type Lease)
1) The lessee records an asset and a
liability at the lower of :
The present value of the MLP
(excluding executory costs); or
The FMV of the leased assest at the
inception of the lease.
Leases
Lessor
(Direct Financing Lease)
1. The lessor records an asset
representing the lease
payment receivable. This
receivable is calculated as
the present value of the
MLP plus the present value
of unguaranteed residual
value (if any).
Receivables = PV of MLP +
PV of UGRV
48
5. Accounting for Finance Leases
Lessee Lessor
(Direct Financing or Sales Type Lease) (Direct Financing Lease)
2) The asset should normally be 2) The lessor takes the property
depreciated over its economic life off the books (generally
unless ownership reverts back to the cost of the property = FMV
lessor in which case the lease term in this type of lease).
should be used.
The recorded asset is depreciated
using the lessees normal
depreciation policy for owned assets
(i.e., depreciation method).
If the residual value is guaranteed,
depreciation is taken down to this
value. Otherwise the asset is fully
depreciated.
Leases 49
5. Accounting for Finance Leases
Lessee
(Direct Financing or Sales Type Lease)
3) The effective interest method 3)
should be used to allocate payments
between repayments of principal
and interest expenses.
(Interest expense = Beginning lease
liability Interest rate;
Repayment of Principal = Lease
payment Interest expense)
The same discount rate used to
calculate the MLP must be used to
calculate the effective interest table.
Leases
Lessor
(Direct Financing Lease)
The lessor records interest
revenue earned over the
lease term by applying the
effective interest method.
(Interest revenue =
Beginning lease receivable
Implicit interest rate)
50
5. Accounting for Finance Leases
Accounting for Sales Type Leases - Lessor:

The primary difference between a direct financing lease

and a sales type lease is the fact that the cost of the asset
to the lessor does not equal its FMV.
The lessor records gross profit (or loss) at the time
he/she takes the leased asset off the books.
The entries are basically the same as for a direct
financing lease. In addition, however, the gross
profit/loss must be recorded as the difference between
sales revenue and cost of goods sold (COGS).
What is included in these entries varies depending if the
residual value is guaranteed or unguaranteed.
Leases 51
5. Accounting for Finance Leases
Guaranteed RV or No Unguaranteed RV
Residual Value
Sales Revenue PV of lease payments + PV PV of minimum lease
of GRV (= PV of MLP) = payments (does not include
lease payment receivable PV of UGRV)

COGS Inventory (Asset) Cost Inventory Cost PV of

UGRV

* Notice that gross profit recognized is the same whether

RV is guaranteed or unguaranteed.

Leases 52
Example 4 (Accounting for finance leases lessee):
Dali Corporation leases equipment from No. 1 Leasing Company with
the following terms:
Lease period: 5 years, beginning January 1, 2014. Noncancellable.
Rental amount: $65,000 per year payable annually in advance;
includes $5,000 to cover executory costs.
Estimated economic life of equipment: 5 years.
Expected residual value of equipment at end of lease period: None.
Assuming the Dali Corporations incremental borrowing rate and the
implicit interest rate of the lease are both 10%, the present value for the
lease would be $250,194, computed as follows:
PV = 60,000 + 60,000 PV ordinary annuity 4|10%
= 60,000 + 60,000 3.1699 = 250,194
Leases 53
Example 4
$5,000 $5,000 $5,000 $5,000 $5,000
Cash
+$60,000 +$60,000 +$60,000 +$60,000 +$60,000
Flow

Time 0 1 2 3 4 5
E(RV) = $0

PV of MLP =$250,194 E(RV) =$0

Leases 54
Example 4 (Contd)
The journal entries to record the lease at the beginning of
the lease term would be:

2014
Jan. 1 Leased Equipment 250,194
Obligation Under Finance Lease 250,194
To record the lease.

Jan. 1 Lease Expense* 5,000

Obligation Under Finance Lease 60,000
Cash 65,000
To record the first lease payment.
Leases 55
Example 4 (Contd)
Remarks:
* The term lease expense is used to record the executory
costs related to the leased equipment. In principle, it is a
prepaid expense (i.e., an asset). Here, we apply the
materiality principle to charge the executory costs to an
expense account immediately.

Leases 56
Example 4 (Contd)
To simplify the schedule, it is assumed that all lease payments after the
first payment are made on December 31 of each year. If the payments
were made in January, an accrual of interest at December 31 would be
required.
Interest Lease
Date Description Amount Expense Principal Obligation
1-1-14 Initial Balance $250,194
1-1-14 Payment $60,000 $60,000 190,194
12-31-14 Payment 60,000 $19,019 40,981 149,213
12-31-15 Payment 60,000 14,921 45,079 104, 134
12-31-16 Payment 60,000 10,413 49,587 54,547
12-31-17 Payment 60,000 5,453 54,547 0
$300,000 $49,806 $250,194
Leases 57
Example 4 (Contd)
Journal entries for Dec 31, 2014:
For a finance lease, lessee carries the leased equipment on his B/S and thus
has to account for depreciation. If the normal company depreciation policy for
this type of equipment is straight-line, the required entry at December 31,
2014, for amortization of the leased asset would be: (For leased assets, we use
amortization rather than depreciation on the lessees books.)
2014
Dec. 31 Amortization Expense on Leased Equipment* 50,039
Acc. Amortization on Leased Equipment 50,039
*250,194/5
Dec. 31 Prepaid Executory Costs** 5,000
Obligation Under Finance Lease 40,981
Interest Expense 19,019
Cash 65,000
Leases 58
Example 4 (Contd)
**Why prepaid?
Because of the assumption that all lease payments after the first
payment are made on December 31, the portion of each payment
that represents executory costs must be recorded as a prepayment
and charged to lease expense in the following year. This is to avoid
double counting the executory costs for 2014. (Recall that we
already had this expense recognized at the beginning of 2014.)
The following journal entry will be made on Jan. 1, 2015:
2015
Jan. 1 Lease Expense 5,000
Prepaid Executory Costs 5,000

Leases 59
Example 4 (Contd)
The December 31, 2014, balance sheet of Dali Corporation:
Dali Corporation
Balance Sheet (Partial)
December 31, 2014
Assets Liabilities
Current assets: Current liabilities:
Prepaid executory costs $5,000 Obligations under finance
leases, current portion $45,079
Land, building & equipment: Noncurrent liabilities:
Leased Equipment 250,194 Obligations under finance
Less: Acc. Amortization 50,039 leases, exclusive of
Net Book Value 200,155 $45,079 included in
current liabilities 104,134

Leases 60
Example 5 (Operating vs. finance lease classification)
On January 1, a firm enters into a noncancelable agreement to
lease equipment for four years. Lease payments of $1,000 are
due each December 31 over the four-year lease term. The
lessees incremental borrowing rate is 12 percent and the rate
implicit in the lease is 10 percent. The economic life of the asset
is five years and the current fair market value of the asset is
$3,500. The estimated (unguaranteed) residual value is $532.

PV of MLP = 1,000 PV ordinary annuity 4|10%

= 1,000 3.1699 = 3,170

While there is neither a title transfer nor a bargain purchase

option, the 75 percent life [the 4 year lease term is >.75 of the
assets 5 year life] and the 90 percent present value [$3,170
present value > (.90)($3,500) fair value of the asset] criteria are
met. Therefore, the lease is a finance lease.
Leases 61
Example 5 (Lease payment paid at the year end)
Cash $1,000 $1,000 $1,000 $1,000
Flow

Time 0 1 2 3 4 5

E(RV) =$532
PV of MLP = $3,170

FMV = PV of MLP + PV of UGRV

= $3,170 + $532 PV single amount 5|10%
= $3,170 + $532 0.6209 = $3,500

Leases 62
Example 5 (Contd)
To calculate the present value of the lease payment, we use the
minimum discount rate, 10 percent.

Allocation of the four $1,000 payments

Opening Closing
Year liability To Interest Expense To Principal Liability
1 $3,170 (0.1)($3,170)=$317 ($1,000 317)=$683 $2,487
2 $2,487 (0.1)($2,487)=$249 ($1,000 249)=$751 $1,736
3 $1,736 (0.1)($1,736)=$174 ($1,000 174)=$826 $910
4 $910 (0.1)($910)=$ 90 ($1,000 90)=$910 $ 0

Leases 63
Example 5 (Contd)
Comparative Analysis of Finance vs. Operating Leases
(Lessees Balance Sheet)

Operating
Finance Lease Lease
Year Net Leased Lease Liability: Lease Liability: Lease Asset
End Asset Current Portion Long-term Portion and Liability
1 $2,378* $751 $1,736 $ 0
2 $1,585 $826 $ 910 $ 0
3 $793 $910 $ 0 $ 0
4 $ 0 $ 0 $ 0 $ 0

* Straight-line depreciation expense = $3,170/4 = $792.5. Net leased asset

at the end of the first year = $3,170 792.5 = $2,378 (rounding).
Leases 64
Example 5 (Contd)
Comparative Analysis of Finance vs. Operating Leases
(Lessees Income Statement)
Operating
Finance Lease Lease
Year Amortization Interest Total Rental
Expense Expense Expense Expense
1 $792 $317 $1,109 $ 1,000
2 $793 $249 $1,042 $ 1,000
3 $792 $174 $ 966 $ 1,000
4 $793 $ 90 $ 883 $ 1,000
Total $3,170 $830 $4,000 $ 4,000

Leases 65
Example 5 (Contd)
Comparative Analysis of Finance vs. Operating Leases
(Lessees Cash Flow Statement)
Finance Lease Operating Lease
Year CF Operations CF Financing CF Operations
1 $317 $683 $ 1,000
2 $249 $751 $ 1,000
3 $174 $826 $ 1,000
4 $ 90 $910 $ 1,000

Leases 66
Example 5 (Contd)
Summary of the Effect on Lessees Financial Statements
(Statement Totals)
Statement Totals Finance Lease Operating Lease
Assets Higher Lower
Liabilities Higher Lower
Net income (in early years) Lower Higher
Cash flow from operations Higher* Lower
Cash flow from financing Lower** Higher
Total cash flow Same Same

* Interest payment only, since amortization is a noncash expense

** Repayment of lease liability

Leases 67
Example 5 (Contd)
Summary of the Effect on Lessees Financial Statements
(Ratios)
Ratios Finance Lease Operating Lease
Current ratio: CA/CL Lower* Higher
Working capital: CACL Lower Higher
Asset turnover: Sales/TA Lower Higher
Return on Assets: EAT/TA (in early years) Lower** Higher
Return on Equity: EAT/E (in early years) Lower** Higher
Debt to Equity: D/E Higher Lower

* Under finance lease, current liability includes the current portion of lease
liability.
** In early years, total lease expense under finance lease (= amortization exp
+ interest) is usually greater.
Leases 68
Example 6 (Accounting for finance lease with bargain
purchase option - lessee):
Assume in Example 4 that:
There was a bargain purchase option of $75,000 exercisable
after five years.
The economic life of the equipment was expected to be 10
years with no residual value. (Note: this is a complete different
asset that has a 10-year useful life).
The other lease terms remain the same.

Leases 69
Example 6
$5,000 $5,000 $5,000 $5,000 $5,000
Cash
+$60,000 +$60,000 +$60,000 +$60,000 +$60,000
Flow

Time 0 1 2 3 4 5
E(RV) = $0

PV of MLP =$296,762 BPO =$75,000

Leases 70
Example 6 (Contd)
The present value of the minimum lease payments would be
increased by the present value of the bargain purchase amount of
$75,000 or $46,568 computed as follows:
PV = 75,000 PV single amount 5|10%
= 75,000 0.6209 = 46,568
The total present value of the future minimum lease payments is
$296,762 ($250,194 + 46,568).
This amount will be used to record the initial asset and liability.
The asset balance of $296,762 will be amortized over the asset life of
10 years because of the existence of the bargain purchase option; this
makes the transaction, in reality, a sale.
The liability balance will be reduced as shown in the following table.
Leases 71
Example 6 (Contd)
Schedule of Lease Payments [Five-Year Lease With Bargain Purchase
Option of $75,000 After Five Years, $60,000 Annual Payments (Net of
Executory Costs), 10% Interest]
Interest Lease
Date Description Amount Expense Principal Obligation

1-1-14 Initial Balance $296,762

1-1-14 Payment $60,000 $60,000 236,762
12-31-14 Payment 60,000 $23,676 36,324 200,438
12-31-15 Payment 60,000 20,044 39,956 160,482
12-31-16 Payment 60,000 16,048 43,952 116,530
12-31-17 Payment 60,000 11,653 48,347 68,183
12-31-18 (BPO) Payment 75,000 6,817 68,183 0
$375,000 $78,238 $296,762

Leases 72
Example 6 (Contd)
At the date of exercising the bargain purchase option:
2018
Dec. 31 Obligations Under Finance Leases 68,183
Interest Expense 6,817
Cash 75,000
To record exercise of the bargain purchase option.
Dec. 31 Equipment 148,381
Accumulated Amortization on Leased Equipment* 148,381
Leased Equipment 296,762
To transfer remaining balance in leased equipment account to equipment
account.
* Accumulated amortization: $296,762 10 years = $29,676 per year
(rounded). 5 years $29,676 per year = 148,381 (rounded).
* Notice that no gain or loss is recognized when a leased asset is purchased
via exercising the BPO.
Leases 73
Example 6 (Contd)
If the equipment is not purchased and the lease is permitted to lapse,
a loss equal to the difference between the equipments remaining
book value and the remaining balance in the lease liability account
(including accrued interest) would have to be recognized by the
following entry: ($148,381 $75,000 = $73,381)
2018
Dec. 31 Loss From Failure to Exercise BPO 73,381
Obligations Under Finance Leases 68,183
Interest Expense 6,817
Accumulated Amortization on Leased Equipment 148,381
Leased Equipment 296,762

Leases 74
Example 7 (Accounting for finance lease with
guaranteed residual value - lessee):
If the lease agreement requires the lessee to guarantee a
residual value, the lessee treats the guarantee similar to a
bargain purchase option and includes the present value of the
guarantee as part of the capitalized value of the lease.
Lets consider the same problem as in the preceding example
but assume the expected residual value after 5 years is $75,000
= guaranteed residual value.
Further assume that the lease is a finance lease because PV of
MLP 90% FMV. As such, the leased asset is depreciated over
the lease term and depreciation is taken down to the GRV.

Leases 75
Example 7 (Contd)
If the fair value of the leased asset at the end of the lease term is equal to or
greater than the guaranteed residual value, the journal entry would be:
2018
Dec. 31 Obligations Under Finance Leases 68,183
Interest Expense 6,817
Accumulated Amortization on Leased Equipment* 221,762
Leased Equipment 296,762
To record the return of the leased asset.

* Accumulated amortization: ($296,762 75,000) 5 years = $ 44,352 per

year (rounded). 5 years $44,352 per year = $221,762 (rounded).
Short-cut: Accumulated amortization at the end of the lease term
= Depreciable cost = Asset cost GRV
= $296,762 75,000 = $221,762
Leases 76
Example 7 (Contd)
If the fair value of the leased asset is less than the guaranteed residual value,
a loss is reported for the difference, and the lessee must make up the
difference with a cash payment. In our example, if the actual FMV of the
equipment returned is $65,000, then you ADD this journal entry:

2018
Dec. 31 Loss on Residual Value Guarantee 10,000
Cash 10,000

Leases 77
Example 8 (Accounting for direct financing lease -
lessor):
Lets use the Dali example without the BPO or GRV, and the
estimate residual value = 0. (Same as Example 4.)
Assume the $5,000 executory costs are paid by the lessor and
charged to the lessee.

Record initial lease:

2014
Jan. 1 Lease Payments Receivable 250,194
Equipment Purchase for Lease 250,194

Leases 78
Example 8 (Contd):
Receipt of first lease payment:
2014
Jan. 1 Cash 65,000
Lease Payments Receivable 60,000
Executory Costs 5,000
The entry regarding the payment of executory costs would be:
2014
Jan. 1 Executory Costs 5,000
Cash 5,000
Receipt of second lease payment:
2014
Dec. 31 Cash 65,000
Interest Revenue 19,019
Lease Payments Receivable 40,981
Deferred Executory Costs (Liability) 5,000
Leases 79
Example 9 (Accounting for direct financing lease
with GRV - lessor):
Lets use the Dali example with the GRV = $75,000.

Record initial lease:

2014
Jan. 1 Lease Payments Receivable* 296,762
Equipment Purchase for Lease 296,762

*PV of MLP = PV of lease payment plus PV of GRV

Leases 80
Example 9 (Contd)
When lessee returns the equipment:
(i) If the equipment has a $75,000 FMV:
2018
Dec. 31 Equipment 75,000
Lease Payments Receivable 68,183
Interest Revenue 6,817

(ii) If the equipment has a $65,000 FMV:

2018
Dec. 31 Equipment 65,000
Cash 10,000
Lease Payments Receivable 68,183
Interest Revenue 6,817

Leases 81
6. Initial Direct Costs
Lessors may incur some initial direct costs associated with the lease
such as commissions, credit investigations, and legal fees.
According to HKAS 17, initial direct costs cannot be expensed
when incurred, meaning the expense will be recognized over the
lease term, rather than in the current year.

Leases 82
The treatment of initial direct costs depends on the nature of the lease.

Operating Leases: Initial direct costs are recorded as assets and

amortized over the lease term, usually on a straight-line basis.
Direct Financing Leases: Initial direct costs are added to the initial
measurement of the lease payments receivable and then amortized
over the lease term. This will impact on the calculation of the
interest rate implicit in the lease and therefore reduce the amount
of income recognized over the lease term.
Receivables (= Equipment Purchase for Lease + Initial Direct
Costs) = PV of MLP + PV of UGRV
Sales-type Leases: Initial direct costs are charged to income
statement when the selling profit is recognized, i.e., they are
added to COGS. This will reduce gross profit from the lease.

Leases 83
Example 10 (Accounting for initial direct costs
under an operating lease - lessor):
Assume that the equipment leased for five years by No. 1 Leasing
Company to Dali Corporation on January 1, 2014, for $65,000 a year,
including executory costs of $5,000 per year, had a cost of $400,000 to
the lessor, No. 1 Leasing.
Initial direct costs of $15,000 were incurred to obtain and finalize the
lease. (According to HKAS 17, initial direct costs under operating
leases should be recorded as an asset and amortized over the lease term.)
The equipment has an estimated life of 10 years, with no residual value.
Assuming no purchase or renewal options or guarantees by the lessee,
the lease does not meet any of the four classification criteria and would
be treated as an operating lease.

Leases 84
Example 10 (Contd)
The entries to record the payment of the initial direct costs and the
receipt of the lease payments by No. 1 Leasing would be:
2014
Jan. 1 Initial Direct Costs (Asset) 15,000
Cash 15,000
Jan. 1 Cash 65,000
Rent Revenue 60,000
Executory Costs 5,000
The $5,000 payment received from the lessee to reimburse the
executory costs is reflected as a credit (reduction) to the executory
expense account. When this payment is made (to a third party), the
entry would be:
Jan. 1 Executory Costs 5,000
Cash 5,000
Leases 85
Example 10 (Contd)
Assuming the lessor depreciates the equipment on a straight-line basis
over its expected life of 10 years and amortizes the initial direct costs on
a straight-line basis over the five-year lease term, the depreciation and
amortization entries at the end of the first year would be:

2014
Dec. 31 Amortization of Initial Direct Costs (I/S item) 3,000
Initial Direct Costs ($15,000/5) 3,000
Dec. 31 Depreciation Expense* 40,000
Accumulated Depreciation ($400,000/10) 40,000

* For lessor, we still use depreciation rather than amortization because

it is an owned asset to the lessor.
Leases 86
Example 11 (Accounting for initial direct costs under
a sales-type lease - lessor):
Consider Dalis example without BPO or GRV (and estimated RV = 0), and
with a manufacturing cost of $160,000 and an initial direct cost of $15,000.
(According to HKAS 17, initial direct costs under sales-type leases should
be recognized as reduction in manufacturers profit.)
Initial lease journal entry:
2014
Jan. 1 Initial Direct Costs 15,000
Cash 15,000
Jan. 1 Lease Payments Receivable 250,194
COGS 175,000
Inventory 160,000
Initial Direct Costs 15,000
Sales 250,194
Leases 87
Example 11 (Contd)
Why are we crediting Initial Direct Cost?
The initial direct costs are charged to the income statement when the selling
profit is recognized by increasing Cost of Goods Sold by the amount expended
for these costs. This reduces the amount of immediate profit to be recognized.

What is the lessor-manufacturers profit?

Show the journal initial entry if there is a BPO or GRV of $75,000. Everything
else is the same.
Jan. 1 Lease Payments Receivable 296,762
COGS 175,000
Inventory 160,000
Initial Direct Costs 15,000
Sales 296,762
What is the lessor-manufacturers profit this time?
Leases 88
Example 11 (Contd)
Now suppose that there is no BPO or GRV but the expected residual
value is $75,000.
Jan. 1 Lease Payments Receivable 296,762
COGS (175,000 46,568) 128,432
Inventory 160,000
Initial Direct Costs 15,000
Sales 250,194

What is the lessor-manufacturers profit this time?

Leases 89