CHAPTER 15
Leases
Overview
In the previous chapter, we saw how companies account for their long-term debt. The focus
of that discussion was bonds and notes. In this chapter we continue our discussion of debt, but
we now turn our attention to liabilities arising in connection with leases. Leases that produce
such debtor/creditor relationships are referred to as capital leases by the lessee and as either
direct financing or sales-type leases by the lessor. We also will see that some leases do not
produce debtor/creditor relationships, but instead are accounted for as lease agreements. These
are designated operating leases.
Learning Objectives
●LO1 Identify and describe the operational, financial, and tax objectives that motivate leas-
ing.
●LO2 Explain why some leases constitute rental agreements and some represent
purchases/sales accompanied by debt financing.
●LO3 Explain the basis for each of the criteria and conditions used to classify leases.
●LO4 Record all transactions associated with operating leases by both the lessor and lessee.
●LO5 Describe and demonstrate how both the lessee and lessor account for a capital lease.
●LO6 Describe and demonstrate how the lessor accounts for a sales-type lease.
●LO7 Describe the way a bargain purchase option affects lease accounting.
●LO8 Explain how lease accounting is affected by the residual value of a leased asset.
●LO9 Explain the impact on lease accounting of executory costs, the discount rate, initial
direct costs, and contingent rentals.
●LO10 Explain sale-leaseback agreements and other special leasing arrangements and their
accounting treatment.
●LO11 Discuss the primary differences between U.S. GAAP and IFRS with respect to leases.
Lecture Outline
Part A: Accounting by the Lessor and Lessee
I. Advantages of Leasing
A. Leasing is used as a means of “off-balance-sheet financing.”
1. Can avoid negatively affecting the debt-equity ratio and other mechanical
indicators of riskiness.
2. Assumes market is naive, and is “fooled” by off-balance-sheet financing.
B. Achieves operational objectives by facilitating asset acquisition to overcome:
1. Uncertainty or cash flow problems.
2. Time constraints and/or bureaucratic control systems.
3. Fear of obsolescence.
C. Achieves tax objectives: A lessee often can negotiate lower lease payments if it allows
the lessor to retain ownership and thus benefit from depreciation deductions when:
1. The lessee has little or no taxable income and will get little benefit from
depreciation deductions.
2. The lessee has sufficient taxable income to take advantage of the depreciation
deductions, but is in lower tax brackets than lessors.
II. In keeping with the concept of “substance over form” a lease is accounted for as either:
A. A lease agreement or
B. A purchase/sale accompanied by debt financing (T15-1)
III. Lease Classification (T15-2)
A. A lessee should classify a lease transaction as a capital lease if it is noncancellable and
if one or more of four classification criteria are met: (T15-2)
1. The agreement specifies that ownership of the asset transfers to the lessee.
2. The agreement contains a bargain purchase option.
3. The noncancellable lease term is equal to 75% or more of the expected
economic life of the asset.
4. The present value of the minimum lease payments is equal to or greater than
90% of the fair value of the asset.
B. Otherwise, it is an operating lease.
C. A lessor records a lease as a direct financing lease or a sales-type lease only if two
conditions relating to revenue realization are met in addition to one of the four
classification criteria.
1. The collectibility of the lease payments must be reasonably predictable.
2. If any costs to the lessor have yet to be incurred, they are reasonably
predictable. (Performance by the lessor is substantially complete.)
IV. Operating Leases (T15-3)
A. We assume that the fundamental rights and responsibilities of ownership are retained by
the lessor and that the lessee merely is using the asset temporarily.
B. A “sale” is not recorded by the lessor;
C. A “purchase” is not recorded by the lessee.
D. Instead, the periodic lease payments are accounted for merely as rent: (T15-4)
1. Rent revenue by the lessor,
2. Rent expense by the lessee.
E. Advance payments are considered prepayments of rent. They are deferred and
allocated to rent over the lease term. (T15-5)
1. A refundable security deposit is recorded as a long-term receivable (by the lessee)
and liability (by the lessor) unless it is not expected to be returned.
2. A prepayment of the last period’s rent is recorded as prepaid rent and allocated to
rent expense/rent revenue during the last period of the lease term.
F. The cost of a leasehold improvement is depreciated over its useful life to the lessee.
(T15-5)
V. Capital Leases (T15-6)
A. In a capital lease the lessee records a leased asset at the present value of the minimum
lease payments.
B. A capital lease is recorded by the lessor as a sales-type lease or direct financing lease,
depending on whether the lease provides the lessor a dealer’s profit.
C. Interest accrues at the effective rate on the balance outstanding during the period.
