In a lease arrangement, the owner-lessor agrees to rent an asset (machinery, equipment, land, or building) to the tenant-lessee for a set number of periods at a fixed rental fee per period. Leases can be broadly classified as either operating leases or capital leases. If the lease agreement transfers a “material ownership interest” from the lessor to the lessee, it is a capital lease. If not, it is an operating lease. Material ownership interests, operating leases, capital leases, and sales-leaseback arrangements are the subjects of this chapter and will be discussed in detail in the following pages.

Operating Leases

Operating leases are the simplest type of lease arrangement from an accounting viewpoint. The rentals are considered to be revenue to the owner-lessor and expenses to the tenant-lessee. If rentals are received in advance, they should be recorded as un-earned rent (a liability) by the lessor and as prepaid rent (an asset) by the lessee. As time goes by, adjusting entries should be made to slowly recognize these items as revenue and expense, respectively. In addition, the lessor should be the one to record the annual depreciation entry since the asset still belongs to him or her.

Example:

On January 1, 20X5, Lessor rents a building for 3 years to Lessee at a fixed rental of $6,000 per year. The total rental of $18,000 is received immediately. The building cost Lessor $25,000 and has a life of 5 years with no salvage value. The journal entries for year 1 are:

On December 31, 20X6 and 20X7, entries would once again be made by both parties to recognize $6,000 as revenue and expense, respectively.

If there are any initial direct costs incurred by the lessor in consummating the lease agreement, they should be debited to an intangible asset account and then gradually be amortized and matched against the annual revenue. Such costs include legal fees, credit report fees, accounting fees, and commissions.

If in the previous example Lessor incurred $600 of initial direct costs, then Lessor would make the following journal entry:

[Debit]. Lease Initiation Fees = $600
[Credit]. Cash = $600

In addition, Lessor would also make the following journal entry each December 31:

[Debit]. Lease Initiation Expense = $200
[Credit]. Lease Initiation Fees = $200*

Note: *$600/3 = $200

Capital Leases

If a lease agreement fulfills certain conditions that indicate that a transfer of a “material ownership interest” has taken place, the lease requires special accounting treatment. Material ownership interest has been defined as a transfer of most of the risks and rewards of ownership.

Fulfillment of any one of the following conditions indicates a material ownership interest:

1. The lease agreement transfers title to the lessee at the end of the lease term.
2. The lessee has the option of buying the asset at a bargain price (“bargain purchase option” or “BPO”) at the end of the lease term.
3. The present value of the annual annuity of rentals is greater than, or equal to, 90% of the fair market value of the asset at the lease inception date.
4. The lease term is equal to 75% or more of the asset’s life.

What is the “special accounting treatment” required if any one of the above conditions is met? The answer is that we “make-believe” the lessor sold this asset, instead of merely renting it. Thus, each payment is not a “rental” payment, but an installment payment on the purchase price.

Legally, this transaction is a rental; in economic substance, however, it is a sale. To ignore the economic substance would make this company’s financial statements incomparable to the statements of companies that made a “real” sale.

In addition to the four conditions mentioned earlier, two additional conditions must both be met for the lessor to treat this transaction as a sale. They are:

1. Collectibility of the lease payments must be reasonably assured.
2. No important uncertainties surround the amount of un-reimbursable costs yet to be incurred by the lessor under the lease agreement.

If these conditions have not been met, then the lessor would not consider the transaction to be a sale, while the lessee would. The result is ironic: two parties to the same agreement treat this agreement in two different accounting ways.

Leases that meet any one of the four conditions mentioned (and the two additional conditions for the lessor) are referred to as capital leases.

There are two types of capital leases: “Direct Financing” and “Sales-Type”.

In a direct financing lease, the lessor does not make a profit at the time of sale; in a sales-type the lessor does.

Let’s make some examples for easier determination…

Lessor rents a building with a life of 4 years to Lessee for 3 years. Let’s assume that the two special conditions for the lessor have been met. This is considered a capital lease since the lease life is 75% of the building’s life.

Lessor rents a building with a life of 4 years to Lessee for 2 years. Thus the 75% test has not been met. However, the fair market value of the building is $100,000 and the present value of the rentals is $92,000. Since the present value is greater than or equal to 90% of the fair market value, this is a capital lease.

Lessor rents a building to Lessee that has a cost to Lessor of $100,000. If the present value of the lease payments is greater than $100,000, then Lessor has made a profit and the lease is thus considered to be a sales-type lease.

Read on for the details…..

Direct Financing Leases

As mentioned previously, if the lease agreement meets the necessary conditions for a capital lease and the lessor does not make a profit on the sale, the lease is a direct financing lease, and the asset is considered to have been sold. Each annual payment on the lease is not a rental payment, but a partial payment of the purchase price obligation. Interest accrues annually on this obligation and must be recorded.

The Lessee will record the asset at the present value of the annual lease payments, and will also record the depreciation. However, if the present value exceeds the asset’s fair market value, then the fair market value should be used instead.

The annual lease payment is determined by the lessor using the following formula:

Example:

Lessor leases a building to Lessee for 4 years starting January 1, 20A. Both the cost to Lessor and the selling price are $50,000. There will be four lease payments, with the first one starting immediately on January 1, 20A. (Thus we are dealing with an annuity due situation.) The building has a 4-year life with no salvage value. Lessor’s target rate of return is 10%. This lease meets the 75% test (the lease term is at least 75% of the life—here it is 100% of the life) and is therefore, a capital lease. Using the above formula, the annual lease payment calculation is:

Both the lessor and lessee will make entries on their books indicating that a sale/purchase has taken place. The lessor will credit the asset and debit a receivable; the lessee will debit the asset and credit a payable for the present value of the annuity of lease payments. If the lessee is not aware of the target rate used by the lessor, then the lessee should use his or her own “incremental borrowing rate”—the rate the lessee would pay to borrow funds in the market. If the lessee is aware of the lessor’s target rate, then he or she should use the lower of the two rates.

Now, let’s assume in the previous example that both rates are 10%. The following journal entries will be made by both parties for 20A:

The entries for the following years would be the same except that the amount for the interest entry would change. It is helpful to prepare an amortization table to determine the annual interest and Lease Receivable/Payable balances.

Next, if we use the same information as in the previous examples, the amortization table would appear as follows:

Column 3 is the balance of column 5 multiplied by 10%. To column 5 we add the interest accrual, and subtract the lease payment.

In addition to annual lease payments, a lease agreement may require the lessee to pay the annual costs of maintaining the asset. These costs include insurance, security, maintenance, etc. Such costs should not be capitalized by the lessee as part of the cost of the asset but should be considered an expense of the period. These costs are called executory costs.

Sales-Type Leases

In a sales-type lease the lessor sets a selling price above the asset cost, thus recognizing an immediate profit at the inception of the lease. Accordingly, the selling price, not the cost, will be used in the numerator in determining the annual rentals, and the amortization table will be based on this price as well.

Example:

Lessor leases a machine having a 3-year life to Lessee for a 3-year lease period. The cost to Lessor was $20,000; the selling price is $25,000. The annual rentals begin immediately on January 1, 19A, and Lessor’s two conditions have been set.

Lessor’s target rate of return is 10% and this rate is known to Lessee. However Lessee’s own incremental rate is 12%. Because Lessor’s rate of 10% is the lower of the two rates, it must also be used by Lessee. The annual rental is computed as follows:

The entries for 19A are:

The amortization table would appear as follows:

For both direct financing and sales-type leases, the lease agreement may specify that under certain conditions the lease terminates early and the asset reverts back to the lessor. In these cases, the lessor will debit the asset at the lower of its original cost or present fair market value, remove the lease receivable, and recognize any gain or loss. The lessee will also remove the lease payable from his or her books and recognize a loss or gain as well.

In the previous example assume that the lease terminates on December 31, 19A, when the balance of the lease receivable/payable is $17,447.14. The fair market value of the machine at this point is $15,000. The journal entries are:

Lessor:

[Debit]. Machine = $15,000
[Debit]. Loss on Lease Termination = $2,447.14
[Credit]. Lease Receivable = $17,447.14

Lessee:

[Debit]. Lease Payable = $17,447.14
[Credit]. Accumulated Depreciation = $8,333.33
[Credit]. Gain on Lease Termination = $780.47
[Credit]. Machine = $25,000