978-1259722660 Chapter 15 Lecture Note Part 1

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. A lease is a contract that gives a

lessee (user) the right to use (or control the use of) an asset for a period of time. The lessee pays the

lessor (owner) for that right, typically with a series of payments made over the lease term. The lessee

initially accounts for this arrangement by recording a “right-of-use” asset and a lease liability at the

beginning of the lease. Subsequent accounting depends on the nature of the lease contract. When the

substance of the lease contract represents a temporary rental agreement between the lessee and

lessor, we classify those as operating leases. However, in situations where the lease contract

essentially represents the sale of an asset, the lessee has a finance lease, and the lessor has a

sales-type lease. As we’ll see in this chapter, the way we account for lease contract depends on how

the lease is classified.

Learning Objectives

LO15–1 Explain the basis for each of the criteria used to classify leases.

LO15–2 Describe and demonstrate how the lessee accounts for a finance lease and the lessor ac-

counts for a sales-type lease with no selling profit.

LO15–3 Describe and demonstrate how the lessor accounts for a sales-type lease with a selling

profit.

LO15–4 Describe and demonstrate how the lessor and lessee account for all transactions associat-

ed with operating leases.

LO15–5 Explain when and how a lessee accounts for a lease by the short-cut method.

LO15–6 Explain the impact on lease accounting of uncertainties, including uncertain lease terms,

variable lease payments, residual values, purchase options, and termination penalties.

LO15–7 Explain the impact on lease accounting of other payments, including nonlease payments,

initial direct costs, and leasehold improvements.

LO15–8 Describe the impact of leases on the statement of cash flows and disclosure requirements

pertaining to leases.

LO15–9 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. Lease Classification

A. In keeping with the concept of “substance over form,” a lease is accounted for as either:

1. A rental or

2. A purchase/sale accompanied by debt financing.

B. A lessee should classify a lease transaction as a finance lease if it is noncancelable and if

one or more of five classification criteria are met:

1. The agreement specifies that ownership of the asset transfers to the lessee.

2. The agreement contains a purchase option that the lessee is reasonably certain to

exercise (bargain purchase option).

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3. The lease term is for the “major part” of the remaining economic life of the

underlying asset.

4. The present value of the total of the lease payments1 equals or exceeds

“substantially all” of the fair value of the underlying asset.

5. The underlying asset is of such a specialized nature that it is expected to have no

alternative use to the lessor at the end of the lease term.

C. Otherwise, it’s an operating lease.

D. A lessor records a non-operating lease as a sales-type lease, either with or without a selling

profit.

II. Finance/Sales-Type Leases

A. In a finance lease, the lessee records a right-of-use asset and a lease liability at the present

value of the lease payments.

B. The lessor records a receivable for a sales-type lease.

1. No selling profit.

2. Selling profit if the present value of the lease payments exceeds the lessor’s cost.

C. Interest accrues at the effective rate on the balance outstanding during the period. Lease

payments (except the first) include interest on the outstanding balance as well as a principal

portion that reduces that outstanding balance.

D. An amortization schedule is convenient to keep up with changing amounts.

E. Amortization is recorded for right-of-use assets in a manner consistent with the lessee’s

usual policy for depreciating its operational assets (usually straight-line).

1. Normally over the term of the lease.

2. Over the asset’s useful life, if:

a. Ownership transfers or

b. A bargain purchase option is present.

III. Sales-Type Leases with Selling Profit

A. A sales-type lease with a selling profit requires recording sales revenue and cost of goods

sold by the lessor at the beginning of the lease. All other entries are the same as in a

sales-type lease with no selling profit. That profit exists when the fair value of the asset

(usually the present value of the lease payments or “selling price”) exceeds the cost or book

value of the asset “sold.”

IV. Operating Leases

A. We assume that the fundamental rights and responsibilities of ownership are retained by the

lessor and that the lessee merely is controlling the use of the asset temporarily.

B. The periodic lease payments are accounted for merely as rent revenue by the lessor on a

straight-line basis over the lease term.

C. The lessee records a right-of-use asset and a lease liability at the present value of the lease

payments. The lessee uses the interest rate implicit in the lease if known or the lessee’s own

incremental borrowing rate otherwise.

1 This total includes any residual value of the asset at the end of the lease term that is guaranteed by

the lessee. We discuss residual values, guaranteed and unguaranteed, later in the chapter.

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D. The lessee records interest the normal way and then “plugs” the right-of-use asset

amortization at whatever amount is needed for interest plus amortization to equal the

straight-line lease payment.

Part B: Uncertainty in Lease Transactions

I. What If the Lease Term Is Uncertain?

A. The lease term is the contractual lease term modified by any renewal or termination options

that are reasonably certain to be exercised.

B. The lease term is reassessed only when a significant event or change in circumstances

indicates a change in the economic incentive to exercise any options to extend or terminate

the lease.

Decision Makers’ Perspective—Considering the Economic Incentive for Exercising Options

A. Most variable lease payments are recognized when incurred rather than being estimated at

lease commencement and included in the lessee’s right-of-use asset and lease liability.

B. If future lease payments are uncertain, we consider them as part of the lease payments only

if they (a) are “in-substance fixed payments” or (b) vary solely when an index or rate

changes.

C. Only if the lease asset and lease liability are later remeasured for another reason will a

change in payments based on the CPI or market interest rates affect the right-of-use asset

and liability.

II. What If the Lease Terms Are Modified?

A. If a modification grants the lessee an additional right of use, the original lease is terminated

and a new lease is created based on the modified arrangement.

B. Modifying lease terms sometimes requires reclassifying an operating lease to a

finance/sales-type lease, or vice versa.

III. Residual Value

A. The residual value is an estimate of what a leased asset’s commercial value will be at the

end of the lease term. A lessee sometimes will guarantee that the lessor will recover a

specified residual value when custody of the asset reverts back to the lessor.

B. If the lessor retains title, the amount to be recovered through periodic lease payments is

reduced by the present value of the residual amount. The value of the asset itself, the

residual value, will provide another source of recovery of the lessor’s investment. That

reduces the amount needed from periodic lessee payments for the lessor to generate its

desired return.

C. The lessor’s lease receivable includes the value of the asset expected at the end of the lease

term.

D. The lessee treats a cash payment that’s predicted due to a lessee-guaranteed residual value

is treated the same as another lease payment.

IV. Purchase Option

A. A purchase option gives the lessee the option to purchase the lease asset at a specified

exercise price.

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B. The exercise price of a purchase option is considered to be an additional cash payment if

exercise of the option is “reasonably certain.”

C. The lessor subtracts the PV of the exercise price to determine lease payments.

D. The lessee adds the PV of the exercise price to determine its asset and liability.

E. When we have a BPO, the length of the lease term is limited to the time up to when the

purchase option becomes exercisable.

Part C: Other Lease Accounting Issues and Reporting Requirements

I. Nonlease Components of Lease Payments

A. Sometimes, as an expedient, a lease contract will specify that the lessor is to pay some

costs for which the lessee will reimburse the lessor through higher lease payments.

B. If a charge represents a transfer of a good or service to the lessee, it’s a separate component

of the lease contract to be separated and expensed by the lessee.

C. The charge should be capitalized as part of the right-of-use asset if it doesn’t transfer a good

or service to the lessee.

II. Initial Direct Costs

A. Initial direct costs are the costs incurred by the lessor that are associated directly with

originating a lease and that would not have been incurred had the lease agreement not

occurred.

B. They include legal fees, commissions, evaluating the prospective lessee’s financial

condition, and preparing and processing lease documents. The method of accounting for

initial direct costs depends on the nature of the lease:

1. For operating leases, initial direct costs are deferred and expensed over the lease

term, generally on a straight-line basis.

2. For sales-type leases with no selling profit, initial direct costs are deferred and

expensed over the lease term. This can be accomplished by not recording the

“prepaid expense” separately but including it in the lease receivable. Then, as

interest revenue is recognized over the lease term at a constant effective rate, the

initial direct costs are recognized at the same rate (that is, proportionally).

3. For sales-type leases that include selling profit, initial direct costs are expensed in

the period of “sale”—that is, at the beginning of the lease. This reflects the notion

that in a sales-type lease, the primary reason for incurring these costs is to

facilitate the sale of the leased asset.

III. Advance Payments

A. Considered prepayments of rent. They are deferred and allocated to rent over the lease

term.

IV. Leasehold Improvements

A. The cost of a leasehold improvement is depreciated over its useful life to the lessee.

V. Statement of Cash Flow Impact

A. Both the lessee and lessor report cash payments for operating leases in a statement of cash

flows as cash flows from operating activities.

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B. Each lease payment in a finance lease includes both an amount that represents interest and an

amount that represents a reduction of principal. In a statement of cash flows, then, the lessee

reports the interest portion as cash flows from operating activities and the principal portion as

cash flows from financing activities.

C. Consistent with reporting sales of products under installment sales agreements rather than

lease agreements, the lessor reports cash receipts from a sales-type lease as cash flows from

operating activities. At the beginning of the lease, the lessor reports the lease as a noncash

investing activity (acquiring one asset and disposing of another) in the disclosure notes to the

financial statements.

VI. Lease Disclosures

A. Lease disclosure requirements are quite extensive for both the lessor and lessee. Virtually all

aspects of the lease agreement must be disclosed. The key objective is that lessees and lessors

provide disclosures that “enable users of financial statements to assess the amount, timing,

and uncertainty of cash flows arising from leases.”

B. Information disclosed is both qualitative and quantitative.

Appendix: Sale-Leaseback Arrangements

I. Sale-Leaseback Transactions

A. In a sale-leaseback transaction, the owner of an asset sells it and immediately leases it back

from the new owner.

B. Sale leaseback accounting is permitted only when the sale portion qualifies as a sale under

the revenue recognition guidelines.

1. If the leaseback qualifies as a finance lease, no sale has occurred.

2. Thus, the only way to have a sale-leaseback transaction is to have a sale (accounted for

as such), followed by an operating lease.

C. If it’s not a sale, we account for the transaction as a loan from the buyer to the seller.

Supplement: GAAP in Effect Prior to ASU No. 2016-02

I. Overview

A. Chapter 15 is based on the lease accounting approach established in Accounting Standards

Update No. 2016-02: “Leases” (Topic 842), which is effective for fiscal years (and interim

periods within those fiscal years) beginning after December 15, 2018.

B. Early adoption was permitted for all companies and organizations upon issuance of the

standard.

Part A: Accounting by the Lessor and Lessee

I. Classification Criteria

A. Preexisting GAAP

1. The agreement specifies that ownership of the asset transfers to the lessee.

2. The agreement contains a bargain purchase option.

3. The noncancelable 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

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the fair value of the asset.

B. ASC 842

1. The agreement specifies that ownership of the asset transfers to the lessee.

2. The agreement contains a purchase option that the lessee is reasonably certain to

exercise.

3. The lease term is for the “major part” of the remaining economic life of the underlying

asset.

4. The present value of the sum of the lease payments equals or exceeds “substantially

all” of the fair value of the underlying asset.

5. The underlying asset is of such a specialized nature that it is expected to have no

alternative use to the lessor at the end of the lease term.

II. Balance Sheet—Lessee

A. The most significant impact of the distinction is its effect on the balance sheet.

B. Preexisting GAAP

1. A capital lease adds to both the asset and liability side of the balance sheet.

2. Operating leases don’t affect the balance sheet at all.

C. ASC 842

1. Designing leases to qualify as operating leases as a way to achieve “off balance sheet

financing” for decades has been a popular and successful practice. Stopping this

practice was the driving force behind the new accounting standard.

2. Lessees recognize a right-of-use asset and a lease liability for all leases (except those

with a lease term of 12 months or less).

III. Balance Sheet—Lessor

A. Preexisting GAAP

1. The difference between a sales-type lease and a direct finance lease is the presence of

selling profit.

B. ASC 842

1. Equivalents are sales-type leases with a selling profit and sales-type leases without a

selling profit.

2. Less common: A direct finance lease only if (a) the “substantially all” criterion has

been met in part due to a third-party residual value guarantee and (b) payments are

collectible.

IV. Income Statement—Lessee

A. The most significant impact of the distinction is its effect on the balance sheet.

B. Preexisting GAAP

1. Capital leases: Interest expense and amortization expense

2. Operating leases: Straight-line lease expense

C. ASC 842

1. Finance leases: Interest expense and amortization expense

2. Operating leases: Straight-line lease expense (by plugging amortization to cause

interest plus amortization to equal the straight-line lease payment)

V. Income Statement—Lessor

A. Preexisting GAAP

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1. Direct financing leases: Interest revenue

2. Sales-type leases: Interest revenue and selling profit

3. Operating leases: Straight-line lease revenue

B. ASC 842

1. Sales-type leases with no selling profit: Interest revenue

2. Sales-type leases with selling profit: Interest revenue and selling profit

3. Operating leases: Straight-line lease revenue

Part B: Additional Differences

I. Lease Term

A. In both preexisting and new GAAP, we adjust the lease term for periods represented by

options that are reasonably certain to be exercised by the lessee.

B. Under both preexisting GAAP and ASC 842, we reassess the lease term if (a) the

provisions of the lease are modified or (b) an option is exercised.

C. Under ASC 842, though, other “triggering events” also can require reassessment.

II. Lease Payments

A. Preexisting GAAP

1. Measurement decisions are made at the inception of the lease under preexisting GAAP.

2. We don’t reassess lease payments unless the lease is modified or an option is

exercised.

B. ASC 842

1. Measurement decisions are made at the commencement (beginning) of the lease under

new GAAP.

2. Reassessment of the lease payments may be triggered by a reassessment of the lease

term, and requires a remeasurement of the lease liability and right-of-use asset. When

remeasuring the lease liability, the lessee will use whatever interest rate prevails on the

remeasurement date.

III. Residual Value

A. Lessor accounting for a residual value is the same under either preexisting GAAP or new

GAAP.

1. It contributes to the total amount to be recovered by the lessor and thus reduces the

amount of the periodic lease payments.

2. Its present value is included along with the present value of the periodic lease

payments as the lessor’s net investment (that we record as a lease receivable).

3. It is a component of lease payments when classifying a lease (present value of lease

payments constitutes 90% under preexisting GAAP/“substantially all” of the assets fair

value under new GAAP) only if it is guaranteed (by either the lessee or a third-party

guarantor).

B. Lessee accounting for a residual value is the same under either preexisting GAAP or new

GAAP with one exception:

1. Preexisting GAAP: The lessee considers a guaranteed residual value to be an

additional lease payment

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2. ASC 842: The lessee includes an additional lease payment only if a cash payment is

predicted as a result of a lessee-guaranteed residual value exceeding the prediction of

what the residual value will be.

IV. Executory Costs

A. Preexisting GAAP: Executory costs

B. New GAAP: Nonlease payments

C. Payments for taxes and insurance are executory costs under preexisting GAAP but do not

qualify as nonlease components under new GAAP and thus must be included in the

right-of-use asset and lease liability.

D. The determining factor under the new guidance is whether the charge represents a transfer

of a good or service to the lessee. If so, it qualifies as a “nonlease component” (executory

cost under preexisting GAAP) of the payment and is separated from the lease payments as

an expense (e.g., maintenance expense).

V. Lessor Accounting

A. Lessor accounting is relatively unchanged by ASC 842 other than the terminology

differences and its being updated to align with the new revenue recognition standard.

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