1. Gabriela H. Schneider, CMA; Grant MacEwan College
INTERMEDIATE ACCOUNTING Sixth Canadian Edition KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK
Prepared by
Gabriela H. Schneider, CMA; Grant MacEwan College 2

2. C H A P T E R 21
Leases

3. 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 lessee’s disclosure requirements for capital leases.
4. Identify the lessee’s accounting and disclosure requirements for an operating lease.

4. 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 lessor’s accounting for direct financing leases.
9. Describe the lessor’s accounting for sales-type leases.

5. Learning Objectives
10. Describe the lessor’s accounting for operating leases.
11. Identify the lessor’s 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 lessor’s accounting treatment for initial direct costs.

6. Leases Basics of Leasing Accounting by Lessees Accounting by Lessor
Advantages of leasing
Conceptual nature of a lease
Accounting by Lessees
Capitalization criteria
Accounting for a capital lease
Capital lease method illustrated
Reporting and disclosure-capital leases
Accounting for an operating lease
Reporting and disclosure-operating lease
Illustration of disclosures
Accounting by Lessor
Economics of leasing
Classification
Capitalization criteria
Direct financing lease
Sales-type lease
Operating leases
Reporting and disclosure
Illustration of lessor disclosures
Special Accounting Issues
Residual values
Bargain purchase options
Initial direct costs
Current versus noncurrent
Unsolved problems
Illustrations of Lease Arrangements
Harmon, Inc.
Arden’s Oven Corp.
Mendotta Truck Corp.
Appleland Computer

7. 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

8. 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

9. 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 Lessor
Leased Equipment XXX Lease Receivable (net) XXX
Lease Obligation XXX Equipment XXX

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

11. Capital vs. Operating Lease
Lease Agreement
Is there a Transfer of Ownership or Bargain Purchase Option?
Is Lease Term  75% of Economic Life No No
Is Present Value of Payments  90% of Fair Value No
Yes
Yes
Yes
Capital Lease
Operating Lease

12. 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

13. 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

14. 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

15. 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

16. 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:

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

18. Capital Lease - Example
Lease Terms Given:
Term of 5 years, non-cancellable
Annual payments $25, (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
Lessee’s incremental borrowing rate = 11%
Lessor’s implicit rate =10% (known to lessee)

19. Capital Lease - Example
Does this qualify as a capital lease?
Only one of the tests must be met
Is there a Transfer of Ownership or Bargain Purchase Option?
Is Lease Term  75% of Economic Life?
Is Present Value of Payments  90% of Fair Value? No
PV of payments (n=5, i=10%)
25, =
23, * =
$100,000.00
Yes
Yes
Capital Lease

20. Capital Lease - Example
Entry to record initial lease transaction Leased Equipment 100,000 Lease Liability 100,000
Entry to record initial payment (Jan 1/02) Property Tax Expense 2, Lease Liability 23, Cash ,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

21. Capital Lease - Example
Interest amortization (December 31, 2002) Interest Expense 7, Interest Payable 7, (100,000-23,981.62)*10% = 7, (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)

22. 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

23. Accounting by the Lessor
Leases are classified as either:
Operating Lease
Direct financing Lease
Sales-type Lease
These are capital leases
The determination of a capital or operating lease depends on answering a series of questions

24. Lease Classification - Lessor
Lease Agreement
Remaining unreimbur-seable costs to Lessor estimatible?
Yes
Risk associated with collection normal?
Yes
Does Asset Fair Value = Lessor’s Book Value?
Yes
Does Lease meet any of Lessee’s Capital Lease criteria? No No No No
Yes
Operating Lease
Sales-Type Lease
Direct Financing Lease

25. 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 manufacturer’s or dealer’s 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 the lessor

26. 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

27. 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 Amount to be Recovered $100,000
Payments would then be: $100,000 = $23,
Total payments receivable = 5 * 23, = 119,908.10
Annuity due factor for n=5, i=10%

28. 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:

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

30. 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 manufacturer’s/dealer’s profit margin

31. Sales-Type Lease – Example
Take the same data as in our example, except the asset has been recorded in the Lessor’s 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

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

33. Disclosure Requirements - Lessor
Disclose the net investment in the lease (classified as current and non-current)
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

34. 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

35. COPYRIGHT
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