Chapter 20 Accounting for Leases

Advantages of Leasing from the Lessee’s Viewpoint

1. Financing Benefits

  1. The lease provides 100% financing, so the there is no down payment required.
  2. The lease contracts contain fewer restrictions and provisions making it more flexible than other debt agreements
  3. The leasing arrangement creates a claim that is against only the leased equipment and not all assets.

2.  Risk Benefit. The Lease may reduce the risk of obsolescence and inadequacy.

3.  Tax Benefit. By deducting lease payments, the lessee can write off the full cost of the asset including the part that relates to land.

4.  Financial Reporting Benefit. In certain cases (for operating leases), the lease does not add a liability to the lessee’s balance sheet and does not affect certain financial ratios such as rate of return.

5.  Billing Benefit. For certain contract-type work, leasing may permit the contractor to charge more because the interest element contained in the rental payments is allowed as a contract charge, whereas interest on borrowed money to purchase assets is usually not.

Advantages of Leasing form Lessor’s Viewpoint

1.  A way of indirectly making a sale

2.  An alternative means of obtaining profit opportunity by engaging in a transaction that enables the lessor company to transfer an asset by the lease agreement.

Accounting By Lessee

Operating Lease

An operating lease is a lease that does not meet any one of the four criteria listed in Column A of Exhibit 20-2 (text).

Under the Operating Lease method the Lessee does not capitalize the asset, only a lease expense is recorded.

Capital Lease

In order the lessee to capitalize a lease it must be noncancelable and meet one of the following four requirements:

1.  The lease transfers ownership 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.

If the lease is capital the lessee records an asset and a liability equal to the sum of the present value at the beginning of the lease term, of the minimum lease payments during the lease term.

Accounting By Lessor

From the standpoint of the Lessor, all leases may be classified for accounting purposes as one of the following:

1.  Operating Lease

2.  Direct Financing Lease

3.  Sales-Type Lease

Capitalization Criteria (Lessor)

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 leased property.

Group II

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

2.  No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease (lessor’s performance is substantially complete or future costs are reasonably predictable.

If at the date of the lease agreement the lessor is party to a lease the meets one or more of the Group I requirements and both of the Group II criteria, the lessor shall classify the lease as a direct financing lease or a sales type lease.

From this point, if the lease includes manufacturer’s or dealer’s profit(loss) it is considered to be a sales-type lease. If it does not it is considered a direct financing lease.

All leases that do not qualify as a direct financing or sales-type lease are classified as an operating lease.

Operating Lease (Lessor)

·  Under and operating lease, a lessor company leasing an asset to a lessee retains substantially all the risks and benefits of ownership.

·  Rental receipts are recorded as rental revenue.

·  The leased asset is depreciated in the normal manner and the expense of the period is matched against rental revenue.

Direct Financing Leases (Lessor)

·  The net amount at which the lessor records the receivable must be equal to the cost of carrying value the property.

·  Then net receivable is equal to the present value of the future leas payments to be received.

·  There are two components of the net receivable, gross receivable and the unearned interest.

·  The gross receivable of the lessor includes the lessor includes the sum of:

o  The undiscounted minimum lease payments to be received by the lessor (net of executory cost paid by the lessor) plus

o  The unguaranteed residual value accruing to the benefit of the lessor.

·  The interest rate implicit in the lease is the rate that, when applied to the gross receivable, will discount that amount to a present value that is equal to the net receivable.

Initial Direct Cost Involved in a Direct Financing Lease – of a completed lease transaction include incremental direct cost and certain other direct costs. Incremental direct cost include those cost that result directly from and are essential to the leasing transaction and would not have been incurred by the lessor if the transaction had not occurred.

Sales-Type Leases (Lessor)

·  In distinguishing between a sales-type lease and a direct financing lease, the major differences are the presence of a manufacturer’s or dealer’s profit or loss in a sale-type lease and the accounting for initial direct costs.

·  The manufacturer’s profit of loss is measured as the difference between the following two items:

o  The present value of the minimum lease payments (net of executory costs) computed at the interest rate implicit in the lease

o  The cost or the carrying value of the asset plus any initial direct costs less the present value of the unguaranteed residual value accruing to the benefit of the lessor.