Companies acquire their fixed asset in some different ways. Rather than simply purchase their fixed asset, some companies may choose to lease theirs. You record purchased fixed assets at their cost (purchased amount plus any expenditures related to the purchase,) how about leased ones? How to account fixed assets acquired by leasing?
Leases can be classified into two categories: (a) operating; and (b) capital lease. Companies may enter into one of them or both in acquiring their assets.
A lease is called as an “operating lease” if it is recorded as an expense in the book, and “capital lease” when it is recorded as assets on one side and lease liability in the other side of the book. Piece of cake, isn’t it? Not really. Though, Generally Accepted Accounting Principles require that the recording of a transaction reflect its true economic nature, not its form. The accounting for leases, however, has been a huge obstacle in the side of accounting standard-setters for at least five decades. From the beginning, the crucial issue has been how to require companies to report leased assets and lease liabilities in the balance sheet when a lease constitutes an effective transfer of ownership. Before going forward, let’s have a look at the two major lease classification first. Read on…
Should a Lease Accounted as Operating or Capital Lease?
Back in 2008, I have extensively discussed this topic (“Accounting for Lease: Operating and Capital Lease”). However, in this post I am going to do a quick overview in the light of “how to account fixed asset acquired by leasing,” a very specific topic—not anything lease.
Because the accounting treatment of a lease can have a major impact on the financial statements, the accounting profession has established criteria for determining whether a lease should be classified as an operating or a capital lease. The FASB has outlined four major criterions for a lease to be accounted as capital lease. If a lease is non-cancelable and meets any one of the following four criteria, it is recorded as a capital lease:
1. The lease transfers ownership of the leased asset to the lessee by the end of the lease term.
2. The lease contains an option allowing the lessee to purchase the asset at the end of the lease term at a bargain price, essentially guaranteeing that ownership will eventually transfer to the lessee.
3. The lease term is equal to 75% or more of the estimated economic life of the asset, meaning that the lessee will use the asset for most of its economic life.
4. The present value of the lease payments at the beginning of the lease is 90% or more of the fair market value of the leased asset.
Note that meeting this criterion means that, in agreeing to make the lease payments, the lessee is agreeing to pay almost as much as the cash price to purchase the asset outright.
If just one of the above criteria is met, then the lease agreement is classified as a “capital lease” and is accounted for by the lessee as a ‘debt-financed’ purchase. A lease that does not meet any of the capital lease criteria is considered an “operating lease.”
Keep in mind that these two types of leases are not alternatives for the same transaction. If the terms of the lease agreement meet any one of the capital lease criteria, the lease must be accounted for as a capital lease.
In practice, however, most companies have taken these four criteria as a challenge—and have carefully crafted their lease agreements so that none of the criteria is satisfied, allowing the leases to continue to be accounted for as operating leases. Some interesting accounting manipulations, though, often involve the four lease criteria relates to the last criteria (the 90% threshold for the present value of the minimum lease payments.) They do such manipulation by hiring an insurance company to guarantee a portion of the lease payments. By doing so, a lessee is able to exclude these payments from the present value computations, lowering the present value below the 90% threshold.
Measuring and Recording Capital Lease
As mentioned on the preface, a company may choose to lease rather than purchase an asset. If a lease is a simple, short-term rental agreement, called an “operating lease,”—lease payments are recorded as “Rent Expense” by the lessee and as “Rent Revenue” by the lessor. But, if the terms of a lease agreement meet specific criteria (discussed above,) the transaction is classified as a “capital lease” and is accounted for as if the asset had been purchased with long-term debt. The lessee records the leased property as an “ASSET” and recognizes a “LIABILITY” to the lessor.
To illustrate the measurement and recording of a capital lease, we will assume that Lie Dharma Corporation leases a mainframe computer from Syrex Data, Inc., on December 31, 2012. The lease requires annual payments of $10,000 for 10 years, with the first payment due on December 31, 2013. The rate of interest applicable to the lease is 14% ‘compounded‘ annually, and you’re the one who takes care of the accounting process.
Before going forward, please note that you should be aware that the illustration of a capital lease presented here assumes that lease payments are made at the end of each year, with the present values based on an ordinary annuity. Usually, lease payments are made at the beginning of each lease period, which requires present value calculations using the concept of an annuity in advance or “annuity due”—which is not explained in this post.
Okay. Assuming the lease meets the criteria for a capital lease, Lie Dharma Corporation will record the computer and the related liability at the present value of the future lease payments:
Step-1: Using “Present value” formula below, the factor for the present value of an annuity for 10 payments at 14% is 5.2161.
Step-2. The factor of 5.2161 is multiplied by the annual lease payment to determine the present value. So you would get this: $10,000 x 5.2161 = $52,161.
[Debit]. Leased Computer = $52,161 (fixed asset)
[Credit]. Lease Liability = $52,161 (liability)
Description: Leased a computer from Syrex Data, Inc., for $10,000 a year for 10 years discounted at 14% (=$10,000 x 5.2161 = $52,161).
If Lie Dharma Corporation uses a calendar year for financial reporting, the December 31, 2013, balance sheet will report the leased asset in the “FIXED ASSET” group and the lease liability in the “LIABILITIES” section. That is how you record fixed assets acquired by leasing.
Next, make a schedule of the computer lease payments as presented on the next figure:
Each year the lease liability account balance is multiplied by 14% to determine the amount of interest included in each of the annual $10,000 lease payments. Note, however, that this is the same procedure used with a mortgage when determining the amount of each payment that is applied to reduce the principal and the amount that is considered interest expense.
As you can see, in the table the interest expense is first calculated by multiplying the interest rate times the lease account balance; the principle amount of the payment is calculated by deducting the interest expense from the payment and the lease account balance for the subsequent year is determined by subtracting the principal amount of the payment from the previous years’ lease account balance.
The reminding payment is a reduction in the liability. For example, the first lease payment on the Dec 31, 2012 will be recorded as follows:
[Debit]. Interest Expense = $7,303
[Debit]. Lease Liability = $2,697
[Credit]. Cash = $10,000
Description: Paid annual lease payment for computer ($52,161 x 0.14 = $7,303 and $10,000 – $7,303 = $2,697).
Similar entries would be made in each of the remaining nine years of the lease, except that the principal payment (reduction in Lease Liability) would increase while the interest expense would decrease. Interest expense decreases over the lease term because a constant rate (14%) is applied to a decreasing principal balance.
Although the asset and liability accounts have the same balance at the beginning of the lease term, they seldom remain the same during the lease period. The asset and the liability are accounted for separately, with the asset being depreciated.
How If the Lease Does Not Meet The Capital Lease Criteria?
If so, then it is recorded as “operating lease“. Operating lease is often referred to as a form of “OFF-BALANCE-SHEET-FINANCING,” why? Because of the economic obligation associated with the financing arrangement entered into to secure the use of an asset is not reported on the balance sheet.
Unlike capital lease—where the lease obligation (and an associated leased asset) will appear on the balance sheet of the company using the leased asset, if a company is able to classify a lease as an operating lease according to the criteria outlined on the previous section, NOTHING will appear on the balance sheet. Neither the leased asset nor the lease liability will be recognized.
Because operating leases are not reported on the balance sheet, however, accounting rules require companies to disclose operating lease details in the financial statement notes so that financial statement users will be aware of these off-balance-sheet obligations.
So the first thing to do before attempting to record fixed asset acquired by leasing is to checking the capital lease criterion, see if the lease does or does not meet the criterion.