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Accounting For Lease: Operating and Capital Lease

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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.

 

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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

49 Comments

49 Comments

  1. iwansetia

    Sep 10, 2008 at 4:45 am

    this is what I ‘Ve Been Waiting for…….But I hope it can be more detail..and more fun… thanks Mr Putra …You are excellent

  2. guillel

    Feb 7, 2009 at 2:29 am

    hi, thanks a lot. i am looking forward for more details about leases. i’ve learned a lot. i will have my report about this. more power. very good!!!!

  3. Putra

    Feb 7, 2009 at 3:59 am

    Hi, I am glad you learn a lot! You can dive more deeply into the lease accounting by reading these articles:

    http://accounting-financial-tax.com/2009/01/hidden-risk-behind-the-lease-accounting/

    and tax matter of leases;

    http://accounting-financial-tax.com/2009/01/tax-deductions-for-rents-and-leases/

    and let me know your thoughts after reading 🙂

  4. arc

    Feb 20, 2009 at 12:31 am

    this is different from what we are discussing in class. i hope this wont confuse me. im dying lease!!!

  5. zahid

    Mar 29, 2009 at 4:53 am

    If the capital lease is affecting balance sheet ratios and you want to do something about it, does FASB mention anything about that ? I know it is not possible to convert from Capital to Operating lease but is it possible to get capital lease off the balance sheet?

  6. Putra

    Mar 29, 2009 at 11:26 am

    @Zahid
    There is no way to make any number [not even cents] off the balance sheet. Otherwise stakeholders will find your BS un-balance. hahaha.. just kidding. I know what you meant; “hidding the capital lease”. It is possible to convert the capital lease to operating lease with some tricks. Read another post of mine: http://accounting-financial-tax.com/2009/01/hidden-risk-behind-the-lease-accounting/

    I am sure you will find some idea abou this. But I woul recommand you TO NOT DO THAT.

    You will find the idea.

  7. kireynia

    Apr 5, 2009 at 8:56 am

    hALLO….I want to ask you..How do accounting treatment if lessor repossess asset??Is it the same accounting treatment between leasing company and consumer finance company??Please help me…I am doing my thesis about accounting treatment for repossess asset for consumer finance company…thx..

  8. vijaydev

    Apr 20, 2009 at 6:08 pm

    thank you for your valuable information

    vijaydev

  9. Chuck Foley

    Jul 18, 2009 at 9:21 pm

    Can rental of land only be qualified as a capital lease or does it have to a depreciated asset? I hate to mention this but I’m pressed timewise to give an answer to a client, so I would greatly appreciate a quick response, if at all possible.

    Thanks so much!

  10. Putra

    Jul 19, 2009 at 2:25 am

    Chuck,

    If the 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 that you would amortize over the time period of the lease.

    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 [onwership will be transferred to the lessee – sale type]

    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 [quiet clear]

    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 [see case example in this post]

    4.The lease term is equal to 75% or more of the asset’s life [quiet clear]

    Ciao!

    • Heide

      Oct 27, 2011 at 3:34 pm

      How do you calculate the present value of the minimum lease payments if the lease payments are different from month to month?

  11. william

    Sep 23, 2009 at 11:15 pm

    Hey! Nice job here! I’ll be dropping by from time to time 🙂

  12. Mazhar

    Dec 1, 2009 at 6:31 am

    Hello, Thanks a lot. I was confused on accounting for leases but now I got a clear concept.

  13. Jeff

    Jan 27, 2010 at 9:08 pm

    How about a situation where the remaining useful life is more than the lease term, like the real life situation I find myself in? Say a 3 year lease term after which you must buy the site, with a remaining useful life of 40 years.

  14. Putra

    Jan 28, 2010 at 11:26 am

    Jeff,

    If by entering the initial 3 years lease, you’re bound to acquired the site, then it is a capital lease and you should not expense it. But, if you may or may not acquire the site on your choice, then it is an operating lease [therefore you should expense it] until you’re actually acquire the site.

  15. Matt

    Mar 5, 2010 at 9:45 pm

    For my company’s capitla leases, how do I determine what is booked as current portion vs L/T portion? The equipment value is $5,420, 36 months, with a $185.20 monthly payment. Current year total of $185.20 (*12) = $2,222.41. Is this my current portion of lease obligations ? Is my JE then:

    DR Equipment $5,420
    CR Current Lease Ob $2,222.41
    CR L/T Lease Ob $3,197.59

    Or do I book only the principal amount for the current and L/T portions and ignore the interest component.

    Thanks

  16. IBV

    Mar 14, 2010 at 3:00 am

    How do I write down the balance off me Accum Depreciation for LeaseHold Improimprovements if I terminate my lease sooner than the lease term. Do I offset my equity or hit my P&L depreciation?

    Thanks.

  17. Roger

    Apr 30, 2010 at 12:41 am

    What if the life of the asset, and the FMV is claimed to be indeterminable by the lessor?

    Life of Asset – use MACRS schedule (>20 yr asset no accelerated deprecation.)?

    FMV = cost to build, FMV of similar assets ?

    Oh yeah – and this – IS IT ACCEPTABLE FOR THE LESSEE / LESSOR TO CATEGORIZE THE LEASE DIFFERENTLY. I.E. LESSEE WANTS A CAPITAL LEASE, AND LESSOR WANTS OPERATING LEASE TO CREATE WIN-WIN SCENARIO?

    Thanks…

  18. umairkhan

    May 1, 2010 at 10:24 am

    itz good to read and go through your articles……….well i am confused in balance sheet treatment of lease assets will you suggest some sites where i can clear my concept with practical problems

  19. Carlos

    May 4, 2010 at 1:36 am

    A direct finance lease is “practically a sale” but is legally a rent, what happen at the end of the lease term? Does the property reverse back to the lessor if there is no mention of transfer of ownership in the lease agreement? Real confused!

  20. George

    May 15, 2010 at 12:07 pm

    Finally, a clear and concise explanation of how capital leases should be treated for accounting purposes. Thank you.

  21. Yas

    Jun 18, 2010 at 8:33 am

    Hey Putra
    Thank you so much for your help!
    For the capital lease example, how do you get the annuity present value that leads to the 14339.59?

  22. Besa

    Jul 17, 2010 at 10:38 am

    Hi there,

    I have a question about repossession of property financed by commercial banks, what are the accounting entries required by the bank?
    If the bank

  23. Bill

    Jul 20, 2010 at 3:25 pm

    I invested capital to start a business and now this business can pay me back on monthly basis, I am confuse where these payments will go on p&l, and will these payments will be consider expenses on p&L? the Business is not a corp. but it’s operated under my ss#.

  24. Shahjahan

    Aug 24, 2010 at 7:17 am

    Dear putra
    I have purchase vehicle on lease for five year, after 3 year lease terminate and i pay lease termination fee and acquire the assets from lease co.
    now i have some issues in recording the assets
    1 ) our co policy of depreciation is 5 years so after lease termination with in 3 years can i depreciate the assets for further 2 years as owned assets or for 5 years.
    2) what will be the value of owned assets after conversion.

    Awaiting ur response

    Thanks and regards

  25. DA

    Aug 29, 2010 at 11:12 pm

    Please explain how a lessee accounts for 20% capital cost reduction/down payment on an open-end TRAC lease with a 12-month minimum term. If the underlying lease contract is written to meet FAS 13 operating lease guidelines, does the CCR exceed the 90% rule since the 20% should be amortized across the initial minimum term or can the CCR be spread over the depreciation period of the lease…in this cae 44 months?

  26. jeena

    Oct 14, 2010 at 4:40 am

    Under US GAAP – can the two parties classify the exact same lease differently?

  27. Janiene

    Oct 14, 2010 at 4:55 pm

    since you did not loan the money you need to take the payments as dividends which will be taxed. Or you can just take cash out and record this as a loan from the company to shareholder (to/from asset account)

  28. katie perley

    Nov 8, 2010 at 7:01 pm

    trying to book this scenario:

    cost (includes land, building and equipment) $50,000
    1st 3 years option to buy $25,000
    after 3 yrs seller will finance $25,000
    the first 25,000 was worked off in lieu of cash

    how do i book this?

  29. suresh

    Dec 1, 2010 at 8:21 am

    Hi am very confused regarding accounting entery

  30. Sr Stella

    Dec 6, 2010 at 6:17 pm

    Please tell me about the current issues on IAS 18 Revenue recognition and IAS 17 leases

  31. Lindell L. Estes

    Dec 22, 2010 at 4:16 pm

    Can you please provide what the journal entries would be for the final year for both the lessor and the lessee? Assume once all of the terms are met, that the final payment was $500.

    Thank you,

    Lindell L. Estes

  32. Rob

    Feb 18, 2011 at 6:44 am

    hi. Could you please tell me, If I am the lessee and I have a capital lease on my balance sheet, Do I calculate depreciation expense with residual value? Or in capital lease case there is no salvage value?

    Thank you

  33. Harini

    Mar 11, 2011 at 11:16 am

    Hi Putra,
    How do I calculate the implicate interest rate for a finance lease if it is not given in the question?
    Your assistance with the above will be greatly appreciated.

  34. Joe Spinella, CPA

    Mar 24, 2011 at 7:04 pm

    It easy, you just need to use a calculator (or Excel) and solve for I. I still use my HP 12C, the newer HP 17B is even easier, as it is memu driven. You need to understand just 6 keys, as follows:

    N-Term
    I – Interest Rate (make sure the term & rate are comparable)
    PV – Equipment Cost
    Pmt – Payment
    FV – Residual
    Also, determain the nature of the pmts (either advance or arrears)

    Good Luck
    Joe Spinella, CPA

  35. Joe Spinella, CPA

    Mar 24, 2011 at 7:21 pm

    Hi Lindell,

    For the Lessor, if there is a residual, apply the pmt to the residual on your books. Once your residual is zero code the collected pmt. to residual income on the P&L.

    For the Leasee, charge it as an expense, the cost to use the equipment.

    Good Luck,
    Joe Spinella

  36. sloan

    Mar 31, 2011 at 5:50 am

    Does anyone use EZ13 software for recording your leases. If so do you recomend it?

  37. Shyam

    Apr 6, 2011 at 4:45 am

    Can you please let me know the entries which will be passed by the lessor at the closure of Capital lease-
    1. when the asset is given to lessee at loss
    2. when the asset is given to lessee at profit

    Thanks

  38. Shyam

    Apr 7, 2011 at 4:48 am

    Hi,

    Can someone help me with the below query:

    What entries will be passed by the lessor at the closure of a Capital lease-
    1. when the asset is given to lessee at loss
    2. when the asset is given to lessee at profit

    Thanks

  39. Michelle

    Nov 1, 2011 at 11:52 pm

    Your company, a manufacturer and lessor of equipment, had recently entered into a lease transaction with another company and you, the supervising accountant, are attempting to evaluate the lease agreement to determine the interest return to your company and if that return has met the company’s minimum interest rate requirements.

    While you are aware of the periodic payment required of the lessee you too are aware that there has been a general decline in the economy which has harmfully affected the fair market value of the leased property. If you utilize the normal selling price in the determination of the effective interest return the rate is not sufficiently high. On the other hand, if you use the new selling price, which is lower than the normal selling price, the interest rate is sufficient to meet the company requirements.

    Which “selling price” should be used in calculating the return and which should be used for classification and accounting purposes?

    Any thoughts??

  40. Dan Venti

    Nov 3, 2011 at 9:43 pm

    I am so blown away (amazed) by the depth of your knowledge and the richness of your content. You are an amazing source of knowledge. I applaude you!!

  41. Rosie

    Jan 24, 2012 at 4:52 pm

    What is the tax accounting treatment of the capital lease? Would the interest and rent be considered temporary or permanent differences?

    Nice explanation

  42. hardik

    Jan 31, 2012 at 8:20 am

    If leasee of an operating lease has incured any initial expenditure incedental to that operating lease can he capitalise the same? or does he have to expense it out?

  43. Ayan

    Mar 15, 2012 at 5:11 am

    Hi I have two questions

    What additional criteria are necessary for the lessor to classify the lease as a capital lease?
    What relevant examples, if any, can you provide from your own professional experiences?

  44. Danielle

    May 2, 2012 at 5:58 pm

    I am trying to find out if a capital lease requires us to collect all of the sales tax up front or it can be broken down into the monthly payments.

    Thank you.

  45. semeni azizi

    Nov 24, 2012 at 7:02 pm

    a lessor leased on asset on a five non concealable finance lease from 1january2005, at a rental at $26000 payable annually in advance.The cost of the asset was $100000.
    The lessors corporation tax rate is assumed to be 35% and payment (recovery) of corporation tax takes place nine months after the year end on 31 December .The leased asset is eligible for writing down allowances at the rate of 25%.
    The constant periodic rate 0f return (after tax) on the net cash investment is assumed to be 10 .25% per annul. calculate the net cash investment and the gross earnings for each of the year of the together with the net investment at the end of 2006

  46. Abejide Ranti

    Dec 3, 2012 at 9:47 am

    I work in an operating lease firm(we lease heavy equipment like dozer,excavator etc),i want to ask what is the accounting treatment for purchase and final sale of such equipment.Also i want to ask the accounting treatment for Value added tax and witholding tax

  47. Emmanuel Gegeh

    Feb 10, 2016 at 1:10 pm

    hi…in the situation where the useful life of the asset is five years, and the lease agreement is for three years. given that the asset has a fair value of 60,000 and a residual value of 10,000, but the lease agreement does not say anything about a guaranteed residual value after the lease period, in calculating the total minimum payment, will we also account for guaranteed residual value? if yes how?

  48. Scott

    Apr 12, 2017 at 7:16 pm

    In your final example in a terminated lease, shouldn’t you Debit Accum depreciation and not credit it? Assuming you already took the depreciation expense charge before terminating the lease. Or just charge depreciation expense (debit) as part of the final entry with no accounting for accum depr. Your entry is unbalanced.

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