Leases

Sid Glandon, DBA, CPA

Associate Professor of Accounting
University of Texas at El Paso
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Basics of Leasing
Lease

Contractual agreement between lessor and

lessee
Gives lessee right to use specific property
Specifies duration and rental payments
Executory costs
Taxes, insurance and maintenance
May be assumed by either party
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Advantages
100%

financing at fixed rates

Protection against obsolescence
Flexibility
Less costly financing
AMT problems avoided
Off-balance-sheet financing
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Classification of Leases
Capital

leases

If lease transfers substantially all of the

benefits and risks of ownership
Must be noncancelable
Operating

leases

Do not substantially transfer benefits and

risks of ownership
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Accounting by Lessee
Capitalize

if noncancelable, and

Transfers ownership to lessee, or

Contains bargain purchase option, or
Lease term equal to 75% or more of
estimated economic life of property, or
PV of minimum lease payments equals or
exceeds 90% of fair value of property
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Accounting by Lessee

Bargain Purchase Option

Allows

lessee to buy leased asset

Price significantly lower that expected
fair value at date of option
Determined at inception of lease
Must render option reasonably assured

Economic Life Test

Lease

period equals or exceeds 75% of

assets economic life
Lease term is considered the fixed
noncancelable term of lease
Bargain renewal options are included
If lease starts during last 25% of life of
asset, test cannot be used
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Recovery of Investment
PV

of minimum lease payments equals

or exceeds 90% of fair value
Minimum lease payments
Payments
Guaranteed residual value
Penalty for failure to renew or extend
Bargain purchase option
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Discount Rate
The

lesser of

Lessees incremental borrowing rate, or

The implicit interest rate

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Executory Cost
Insurance,

maintenance and taxes

Should be excluded from minimum
lease payments

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Residual Values
Estimated

fair value at end of lease

Guaranteed residual value
An additional lease payment
Unguaranteed

residual value

Same as no residual value to lessee

Lessor

assumes residual value will be

realized whether guaranteed or not
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Capitalized Leases
Accounting by Lessee
Asset

and Liability

Recorded at the lesser of the PV of

minimum lease payments or FMV
Depreciation

Period

Economic life
Lease transfers ownership
Lease has bargain purchase option

Term of lease
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Fact Pattern

Date: January 1, 2006

Lease term: 10 years
Discount rate: 8%
Annual lease payments: $12,000
Executory costs: $1,000
Title transfers at end of lease term
Economic life of asset: 12 years
Residual value: $0
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Operating Leases
Accounting by Lessee
Lessee

assigns rent to periods

benefiting
Ignores any commitments for future
payments
Note disclosure
For all operating leases that have
noncancelable lease terms in excess of one
year
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Classification of Leases
Accounting by Lessor
Direct

financing leases
Sales type leases
Operating leases

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Direct Financing Lease

Must

meet group I capitalization criteria

and
Collectibility of payments must be
reasonably assured
Lessors performance must be
substantially complete
FV

of asset equal to lessors book value

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Sales Type Lease

Must meet group I capitalization criteria and

Collectibility of payments must be reasonably
assured
Lessors performance must be substantially
complete

FV of asset should not be equal to lessors

book value
Lease contains a dealers gross profit

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Operating Lease
Accounting by Lessor
Does

not meet criteria for capitalized

lease
Rental receipts recorded as rental
receipts
Leased asset depreciated
Leased equipment and accumulated
depreciation separately classified
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Accounting by Lessor

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Direct Financing Lease

Debit,

Lease receivable

Gross sum of lease payments

Credit,

Unearned interest revenue

Lease receivable less FMV of asset

Credit,

Inventory of equipment

Lessors cost of the asset

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Fact Pattern
Date:

January 1, 2005
Inventory of equipment: $103,500
Lease term: 6 years
Implicit interest rate: 8%
Payments: $20,000
Residual value: $5,786
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Sales Type Leases

Debit, Lease Receivable

Lease payments plus residual

Debit, Cost of Goods Sold

Lessors cost

Credit, Sales Price of Asset

PV of minimum lease payments

Credit, Unearned Interest Revenue

Lease Receivable less FMV of asset

Credit, Inventory
Lessors cost
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Fact Pattern
Date:

January 1, 2005
Inventory of equipment: $60,000
FMV of equipment: $103,500
Lease term: 6 years
Implicit interest rate: 8%
Payments: $20,000
Residual value: $5,786
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