Despite recent disagreement between the IASB’s IFRS and FASB’s US-GAAP, on the lease accounting topic, lease transaction has became a popular way for companies to finance long-lived assets, for years. It offers two main advantages: firstly it typically provides a hundred percent financing, secondly it often results in off-the-books obligation. A lease transaction (agreement) involves at least two parties; a lessee and lessor, and an asset that is to be leased.

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While a lessee is the party who is granted (by the lessor) a right to use the leased asset for a specified period of time in return for periodic rent payments, a lessor is the party that either owns or commits to purchase the asset, agrees to grant the lessee the right to use.

But, in this post, I am going to discuss the lessee’s side only as a start. Lease accounting is a wide and complex topic that unless one learns it one at a time, she won’t get the meat. The lease transaction derives its accounting complexity from the number of alternatives available to the parties involved. Leases can be used to transfer ownership of the leased asset, and they can be used to transfer the risks and rewards of ownership. In any event, the substance of the transaction dictates, with certain exceptions, the accounting treatment, irrespective of its legal form. Also, leases can be structured to allow differing assignments of income tax benefits associated with the leased asset to meet the objectives of the transacting parties.

The lease transaction is probably the best example of the accounting profession’s substance over-form argument—if the transaction effectively transfers the risks and rewards of ownership to the lessee, then the substance of the transaction is that of a sale and, accordingly, it is recognized as such for accounting purposes even though the transaction is legally structured as a lease.

 

Accounting for Lease Transaction on Lessee Book

The IAS 17 provides two ways for lessee to account a lease transaction as either:

  • an operating lease; or
  • a finance lease

Let’s start with the operating lease. A typical lease is recorded by the lessee as an operating lease. The lessee accounts for an operating lease by charging lease payments directly to expense. There is no balance sheet recognition of the leased asset at all.

If the schedule of lease payments varies in terms of either timing or amount, the lessee should consistently charge the same rental amount to expense in each period, which may result in some variation between the lease payment made and the recorded expense.

Nevertheless, if there is a demonstrable change in the asset being leased that justifies a change in the lease payment being made, there is no need to use straight-line recognition of the expense.

Operating lease, is a lease that does not meet the criteria prescribed for a finance lease. (see after the case example below)”

Case Example:

The Lie Dharma Putra Inc has leased a group of operating equipment under a five-year operating lease arrangement. The monthly lease cost is $1,000 for the first 30 months and $1,500 for the second 30 months. There is no change in the equipment being leased at any time during the lease period. The correct accounting is to charge the average monthly lease rate of $1,250 to expense during every month of the lease.

For the first 30 months, Lie Dharma Putra would record the rent expense, on monthly basis, by entering the following journal:

[Debit]. Equipment rent expense = $1,250
[Credit]. Accounts payable = $1,000
[Credit]. Accrued lease liability = $250

And, during the final 30 months, the monthly journal entry will be

[Debit]. Equipment rent expense = $1,250
[Debit]. Accrued lease liability = $250
[Credit]. Accounts payable = $1,500

 

Next, let’s have a look at the finance lease. Under the same rule, the lessee must record a lease as a finance lease if a substantial number of all the benefits and risks of ownership have been transferred to the lessee.

Finance lease, is lease that transfers a substantial amount of all the risks and rewards associated with the ownership of an asset. The risks related to ownership of an asset include the possibilities of losses from idle capacity or technological obsolescence and of variations in return due to changing economic conditions; rewards incidental to ownership of an asset include expectation of profitable operations over the asset’s economic life and expectation of gain from appreciation in value or the ultimate realization of the residual value. Title may or may not eventually be transferred to the lessee.

The IAS 17 stipulates that substantially all of the risks or benefits of ownership are deemed to have been transferred if any one of these five criteria has been met:

  • The lease transfers ownership to the lessee by the end of the lease term.
  • The lease contains a bargain purchase option (an option to purchase the leased asset at a price that is expected to be substantially lower than the fair value at the date the option becomes exercisable), and it is reasonably certain that the option will be exercisable.
  • The lease term is for the major part of the economic life of the leased asset; title may or may not eventually pass to the lessee.
  • The present value (PV), at the inception of the lease, of the minimum lease payments is at least equal to substantially all of the fair value of the leased asset, net of grants and tax credits to the lessor at that time; title may or may not eventually pass to the lessee.
  • The leased assets are of a specialized nature such that only the lessee can use them without major modifications being made.

Inception of the lease, is the date of the written lease agreement or, if earlier, the date of a commitment by the parties to the principal provisions of the lease.

Further indicators which suggest that a lease might be properly considered to be a finance lease are:

  • If the lessee can cancel the lease, the lessor’s losses associated with the cancellation will be borne by the lessee.
  • Gains or losses resulting from the fluctuations in the fair value of the residual accrue to the lessee.
  • The lessee has the ability to continue the lease for a supplemental term at a rent that is substantially lower than market rent (a bargain renewal option).

The lessee accounts for a finance lease by recording an asset and an obligation (liability) at an amount equal to the lesser of:

(1) the fair value of the leased property at the inception of the lease, net of grants and tax credits receivable by the lessors; or

(2) the present value of the minimum lease payments.

Fair value of leased property (FMV), is the amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s-length transaction. When the lessor is a manufacturer or dealer, the fair value of the property at the inception of the lease will ordinarily be its normal selling price net of volume or trade discounts. When the lessor is not a manufacturer or dealer, the fair value of the property at the inception of the lease will ordinarily be its cost to the lessor unless a significant amount of time has lapsed between the acquisition of the property by the lessor and the inception of the lease, in which case fair value should be determined in light of market conditions prevailing at the inception of the lease. Thus, fair value may be greater or less than the cost or carrying amount of the property.

For purposes of this computation, the minimum lease payments are considered to be the payments that the lessee is obligated to make or can be required to make, excluding contingent rent and executory costs such as insurance, maintenance, and taxes.

Minimum lease payments (MLPs), from the standpoint of the lessee, it is the payments over the lease term that the lessee is or can be required to make in connection with the leased property. The lessee’s obligation to pay executory costs (e.g., insurance, maintenance, or taxes) and contingent rents are excluded from minimum lease payments. If the lease contains a bargain purchase option, the minimum rental payments over the lease term plus the payment called for in the bargain purchase option are included in minimum lease payments. If no such provision regarding a bargain purchase option is included in the lease contract, the minimum lease payments include:

  • The minimum rental payments called for by the lease over the lease contract over the term of the lease (excluding any executory costs), plus
  • Any guarantee of residual value, at the expiration of the lease term, to be paid by the lessee or a party related to the lessee.

The minimum lease payments generally include the minimum rental payments and any guarantee of the residual value made by the lessee or a party related to the lessee. If the lease includes a bargain purchase option (BPO), the amount required to be paid under the BPO is included in the minimum lease payments. The present value shall be computed using the implicit rate in the lease, if this is practicable to determine; if not, the lessee’s incremental borrowing rate should be used.

Bargain purchase option (BPO), is a provision in the lease agreement allowing the lessee the option of purchasing the leased property for an amount that is sufficiently lower than the fair value of the property at the date the option becomes exercisable. Exercise of the option must appear reasonably assured at the inception of the lease.

The lease term to be used in the present value computation is the fixed, non-cancelable term of the lease, plus any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, provided that it is reasonably certain, as of the beginning of the lease, that lessee will exercise such a renewal option.

The depreciation of the leased asset will depend on which criterion resulted in the lease being qualified as a finance lease:

  • If the lease transaction met the criteria as either transferring ownership or containing a bargain purchase option, the asset arising from the transaction is to be depreciated over the estimated useful life of the leased property, which will be used by the lessee (most likely) after the lease term expires.
  • If the transaction qualifies as a finance lease because it met either the criterion of encompassing the major part of the asset’s economic life or because the present value of the minimum lease payments represented substantially all of the fair value of the underlying asset, then it must be depreciated over the shorter of the lease term or the useful life of the leased property.

The conceptual rationale for this differentiated treatment arises because of the substance of the transaction. Under the first two criteria, the asset actually becomes the property of the lessee at the end of the lease term (or on exercise of the BPO). In the latter situations, title to the property remains with the lessor.

Thus, the leased asset is to be depreciated (amortized) over the shorter of the lease term or its useful life if title does not transfer to the lessee; however, when it is reasonably certain that the lessee will obtain ownership by the end of the lease term, the leased asset is to be depreciated over the asset’s useful life.

Note: The manner in which depreciation is computed should be consistent with the lessee’s normal depreciation policy for other depreciable assets owned by the lessee, recognizing depreciation on the basis set out in IAS 16.

To record the initial capitalization of a lease, including imputed interest that is associated with the transaction and both the short-term and long-term portions of the associated account payable (see below).

[Debit]. Finance leases = xxxxx
[Debit]. Unamortized discount on notes payable = xxxxx
[Credit]. Short-term liabilities = xxxxx
[Credit]. Long-term liabilities = xxxxx

A second entry records the interest expense associated with each periodic payment on the finance lease (see below)

[Debit]. Interest expense = xxxxx
[Credit]. Unamortized discount on notes payable = xxxxx

A third entry records the depreciation expense associated with the finance lease in each accounting period. (see below)

[Debit]. Depreciation expense = xxxxx
[Credit]. Accumulated depreciation—finance leases = xxxxx

 

Finance Lease Transaction Case Example

The Lie Dharma Putra Inc leases a machine under a 5-year lease that has a one-year extension clause at the option of the lessor as well as a guaranteed residual value of $15,000. Lie Dharma Putra’s incremental borrowing rate is 7%. The machine is estimated to have a life of seven years, a current fair value of $90,000 and a residual value of $5,000. Annual lease payments are $16,000.

The first step in accounting for this lease is to determine if it is a finance lease or an operating lease. If it is a finance lease, Lie Dharma would calculate its present value, and use the effective interest method to determine the allocation of payments between interest expense and reduction of the lease obligation, and then determine the depreciation schedule for the asset. Later, there will be a closeout journal entry to record the lease termination. Here are the complete steps:

Step-1. Determine the lease type – The woodworking machine is considered to have a life of seven years; since the lease period—including the extra year at the option of the lessor—exists for the major part of the machine’s economic life, the lease is designated as a finance lease.

Step-2. Calculate asset present value – The machine’s present value is a combination of the present value of the $15,000 residual payment due in six years and the present value of the stream of annual payments of $16,000 per year for six years. Using Lie Dharma Putra incremental borrowing rate of 7%, the present value multiplier for $1 due in six years is 0.6663; when multiplied by the guaranteed residual value of $15,000, this results in a present value of $9,995. Using the same interest rate, the present value multiplier for an ordinary annuity of $1 for six years is 4.7665; when multiplied by the annual lease payments of $16,000, this computes to a present value of $76,264. After combining the two present values, we arrive at a total lease present value of $86,259. The initial journal entry to record the lease will be:

[Debit]. Leased equipment = $86,259
[Credit]. Lease obligation = 86,259

Step-3. Allocate payments between interest expense and reduction of lease liability. Lie Dharma Putra’s controller then uses the effective interest method to allocate the annual lease payments between the lease’s interest expense and reductions in the lease obligation (Note: The interest calculation is based on the beginning balance of the lease obligation.) The calculation for each year of the lease will be as follows:

Lease Transaction By Lessee

Step-4. Create depreciation schedule – Although the asset has an estimated life of seven years, the lease term is for only six years, after which the asset is expected to be returned to the lessor. Accordingly, the asset will be depreciated only over the lease term of six years; however, the amount of depreciation will only cover the asset’s present value of $86,259 minus the residual value of $5,000. Therefore, the annual depreciation will be $13,543 (= ($86,259 present value – $5,000 residual value) / 6-year lease term).

 

Lease Extensions for Lessee

Here is the lease extension rule for lessee:

  • If a lessee extends an operating lease and the extension also is classified as an operating lease, then the lessee continues to treat the extension in the same manner it has used for the existing lease.
  • If the lease extension requires payment amounts differing from those required under the initial agreement but the asset received does not change, then the lessee should consistently charge the same rental amount to expense in each period, which may result in some variation between the lease payment made and the recorded expense.
  • If a lessee extends an existing finance lease but the lease structure now requires the extension be recorded as an operating lease, the lessee writes off the existing asset, as well as all associated accumulated depreciation, and recognizes either a gain or a loss on the transaction. Payments made under the lease extension are handled in accordance with the rules of a standard operating lease.
  • If a lessee extends an existing finance lease and the structure of the extension agreement requires the lease to continue to be recorded as a finance lease, the lessee changes the asset valuation and related lease obligation by the difference between the present value of the new series of future minimum lease payments and the existing balance. The present value calculation must use the interest rate used for the same calculation at the inception of the original lease.

Subleases

A sublease occurs when leased property is leased by the original lessee to a third party. When this happens, the original lessee accounts for the sublease as if it were the original lessor. This means that it can account for the lease as an operating lease, a direct sales lease, or a sales-type lease. The original lessee continues to account for its ongoing lease payments to the original lessor as if the sublease did not exist. Lessee, who subleases, stand as a lessor, if none of the previously noted (for a finance lease) is met, a lease must be treated as an operating lease. If at least one of the five criteria is met and (1) lease payments are reasonably collectible and (2) there are minimal uncertainties about future lessor unreimbursable costs, then the lessee (who now became lessor) must treat a lease as a finance lease and as one of these three lease types:

  • Sales-type lease – When the lessee (as a lessor) will earn both a profit and interest income on a lease transaction.
  • Direct financing lease – When the lessee (as a lessor) will earn only interest income on a lease transaction.
  • Leveraged lease – The same as a direct financing lease, but the financing is provided by a third-party creditor.

 

Lease Terminations

On the date that a lessee notifies the lessor that it intends to terminate a lease, the lessee must recognize a liability for the fair value of the termination costs, including any continuing lease payments, less prepaid rent, plus deferred rent, minus the amount of any sublease payments. Changes in these estimates are recorded immediately in the income statement.