Accounting Chapter 15 Homework Under Ias No 17 Both Parties Lease

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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 leasing.

● 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.

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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.

15-2 Intermediate Accounting, 8/e

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:

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.

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

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

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. Lease

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

portion that reduces that outstanding balance. (T15-7)

D. An amortization schedule is convenient to keep up with changing amounts. (T15-8)

E. Depreciation is recorded for leased assets in a manner consistent with the lessee’s usual

policy for depreciating its operational assets (T15-9)

2. Over the asset’s useful life, if:

a. Ownership transfers or

b. A bargain purchase option is present.

F. A sales-type lease requires recording sales revenue and cost of goods sold by the lessor at

the inception of the lease. All other entries are the same as in a direct financing lease.

(T15-10)

1. The presence or absence of a manufacturer’s or dealer’s profit distinguishes between a

sales-type lease and a direct financing lease.

Part B: Bargain Purchase Options and Residual Value

I. Bargain Purchase Option

When a BPO is present, both the lessor and the lessee view the option price as an additional

II. Residual Value (T15-13)

A lessee-guaranteed residual value is included as a component of minimum lease payments

for both the lessor and the lessee. An unguaranteed residual value is not (but is part of the

lessor’s gross investment in the lease).

A. If the lessee obtains title, the lessor’s computation of lease payments is unaffected by

any residual value.

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. (T15-14)

C. On the other side of the transaction, the lessee considers the “purchase” price of the

copier to include:

2. An amount due to the residual value viewed as an additional “payment” if the

lessee guarantees the residual value to be a particular amount at the end of the

15-4 Intermediate Accounting, 8/e

Part C: Other Lease Accounting Issues

A. Executory costs are maintenance, insurance, taxes, and any other costs usually associated

with ownership. (T15-18)

1. Sometimes, as an expediency, a lease contract will specify that the lessor is to pay

2. Any portion of lease payments that represents executory costs is not considered part of

minimum lease payments.

3. The lessee simply expenses executory costs as incurred.

B. The lessee uses the lower of the interest rate implicit in the lease or the lessee’s own

incremental borrowing rate. (T15-19)

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

originating a lease and are essential to acquire that lease.

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

condition, and preparing and processing lease documents.

2. The method of accounting for initial direct costs depends on the nature of the lease:

a. For operating leases initial direct costs are recorded as assets and amortized over

the term of the lease. Since the only revenue an operating lease produces is lease

revenue, and that revenue is recognized over the lease term, initial direct costs

also are automatically recognized over the lease term to match these costs with

D. Lease disclosure requirements include (a) a “general description” of the leasing

arrangement as well as (b) minimum future payments, in the aggregate, and for each of the

five succeeding fiscal years.

E. Decision-Makers’ Perspective: Financial Statement Impact

1. Balance Sheet and Income Statement

i. Lease liabilities affect the debt equity ratio and the rate of return on assets.

2. Statement of Cash Flow Impact

ii. Each lease payment in a capital 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

Part D: Special Leasing Arrangements

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

from the new owner.

1. A gain on the sale of an asset in a sale leaseback arrangement is deferred and

amortized over the lease term (or asset life if title is expected to transfer to the lessee).

2. The lease portion of the transaction is evaluated and accounted for like any lease.

B. Real estate leases involve land – exclusively, or in part.

1. Only the first (title transfers) and second (BPO) classification criteria apply in a land

lease.

2. When (a) the leased property includes both land and a building, (b) neither of the first

3. Usual lease accounting procedures apply to leases that involve only part of a building

although extra effort may be needed to arrive at reasonable estimates of cost and fair

value.

C. A leveraged lease involves significant long-term, nonrecourse financing by a third party

creditor.

2. A lessor records its investment (receivable) net of the nonrecourse debt and reports

income from the lease only in those years when the receivable exceeds the liability.

15-6 Intermediate Accounting, 8/e

International Financial Reporting Standards

A. The IASB and FASB are collaborating on a joint project for a revision of leasing standards.

The Boards have agreed that a “right of use” model (where the lessee recognizes an asset

representing the right to use the leased asset for the lease term and also recognizes a

corresponding liability for the lease rentals, whatever the term of the lease) is the only

approach which recognizes assets and liabilities that corresponded to the conceptual

SUPPLEMENT: WHERE WE’RE HEADED

A. The right to use leased property can be a significant asset. Likewise, the obligation to

make the lease payments can be a significant liability.

1. Under the proposed Accounting Standards Update (ASU) the lessee reports both the

right-of-use asset and the corresponding liability in the balance sheet.

2. The concept of operating leases is eliminated.

B. Underlying the new ASU is a dual concept of leases:

.

C. Type A Lease

1. The lessee reports both a right-of-use asset and a lease liability.

a. The lease liability is reduced over the lease term as interest is recorded at the

2. The lessor reports a lease receivable and removes the asset from its books. This is an

a. A lessor cannot recognize sales profit (or revenue) at the beginning of any lease (which

is done currently for a sales-type lease) that doesn’t transfer “control” of the

underlying asset to the lessee.

C. Type B Lease

1. The lessee reports both a right-of-use asset and a lease liability.

a. The lease liability is reduced over the lease term as interest is recorded at the

2. The lessor records no entry at the beginning of the lease. This is an approach

substantially equivalent to existing operating lease accounting.

a. Lease revenue is recorded as an equal straight-line amount each period over the

lease term.

b. Depreciation expense is recorded on the asset still on the lessor’s books.

D. A lease that has a maximum possible lease term (including any options to renew or extend)

of twelve months or less is considered a “short–term lease.”

2. In a short-term lease, the lessor can elect not to record the lease at its beginning and

instead simply record lease receipts as lease revenue.

E. Initial direct costs are those associated directly with originating a lease and that would not

have been incurred had the lease agreement not occurred. These include legal fees,

commissions, evaluating the prospective lessee’s financial condition, and preparing and

processing lease documents. Initial direct costs are simply added to the book amount of the

right-of-use asset if incurred by the lessee or to the lease receivable if incurred by the

lessor.

F. There often is uncertainty regarding lease payments, the length of the lease term, and

whether the title will transfer to the lessee.

1. We consider the lease term for both the lessee and the lessor to be the contractual lease

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

3. A cash payment predicted under a lessee-guaranteed residual value is treated the same

as a lease payment. That is, the present value of that payment is added to the present

4. We consider the exercise price of a purchase option to be an additional cash payment

(just like a cash payment predicted under a lessee-guaranteed residual value), which

will increase both the lessee’s lease payable and the lessor’s lease receivable, only if

15-8 Intermediate Accounting, 8/e

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A PowerPoint presentation of the chapter is available at the textbook website.

An alternate version of the PowerPoint presentation also is available.

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The following can be reproduced on transparency film as they appear here, or

BASIC LEASE CLASSIFICATIONS

A lease is accounted for as either a lease agreement

(operating lease) or a purchase/sale accompanied by debt

financing. The choice of accounting method hinges on the

nature of the leasing arrangement. Capital leases are

agreements that we identify as being formulated outwardly as

leases, but which are in reality installment purchases.

Lessee Lessor

● Operating lease ●Operating lease

● Capital lease ● Capital lease:

Direct financing lease

Sales-type lease

T15-1

15-10 Intermediate Accounting, 8/e

CLASSIFICATION CRITERIA

A lessee should classify a lease transaction as a capital lease if it

includes a noncancelable lease term and one or more of the

following four criteria are met. Otherwise, it is an operating lease.

1 The agreement specifies that ownership of the asset

transfers to the lessee.

ADDITIONAL LESSOR CONDITIONS

✓ The collectibility of the lease payments must be

reasonably predictable.

T15-2

OPERATING LEASES

On January 1, 2016, Sans Serif Publishers, Inc., a computer services and printing

firm, leased a color copier from CompuDec Corporation.

The lease agreement specifies four annual payments of $100,000 beginning

January 1, 2016, the inception of the lease, and at each January 1 through 2016. The

useful life of the copier is estimated to be six years.

Before deciding to lease, Sans Serif considered purchasing the copier for its cash

price of $479,079. If funds were borrowed to buy the copier the interest rate would

have been 10%.

✓ How should this lease be classified? We apply the four classification criteria:

1 Does the agreement specify that

ownership of the asset transfers

to the lessee? NO

T15-3

15-12 Intermediate Accounting, 8/e

OPERATING LEASES

At Each of the Four Payment Dates

Sans Serif Publishers, Inc. (Lessee)

Prepaid rent ………………………………………………. 100,000

At the End of Each Year

Sans Serif Publishers, Inc. (Lessee)

T15-4

ADVANCE PAYMENTS

 Advance payments are considered prepayments of rent. They

are deferred and allocated to rent over the lease term.

LEASEHOLD IMPROVEMENTS

 Sometimes a lessee will make improvements to leased

T15-5

15-14 Intermediate Accounting, 8/e

DIRECT FINANCING LEASES –

LESSEE AND LESSOR CALCULATIONS

On January 1, 2016, Sans Serif Publishers, Inc. leased a copier

from First LeaseCorp. First LeaseCorp purchased the

equipment from CompuDec Corporation at a cost of $479,079.

Calculations:

Lessor:

$479,079 ÷ 4.79079** = $100,000

Lessee:

$100,000 x 4.79079** = $479,079

DIRECT FINANCING LEASES –

LESSEE AND LESSOR ENTRIES

Direct Financing Lease [January 1, 2016]

Sans Serif Publishers, Inc. (Lessee)

First Lease Payment [January 1, 2016]

Sans Serif Publishers, Inc. (Lessee)

T15-6 (continued)

15-16 Intermediate Accounting, 8/e

DIRECT FINANCING LEASES –

SECOND LEASE PAYMENT

Second Lease Payment [December 31, 2016]

Sans Serif Publishers, Inc. (Lessee)

T15-7

LEASE AMORTIZATION SCHEDULE

Effective Decrease Outstanding

Payments Interest in Balance Balance

10% x Outstanding Balance

1/1/16 479,079

1/1/16 100,000 100,000 379,079

T15-8

15-18 Intermediate Accounting, 8/e

DEPRECIATION

 Depreciation is recorded for leased assets in a manner

consistent with the lessee’s usual policy for depreciating its

operational assets.

End of Each Year

Sans Serif Publishers, Inc. (Lessee)

The lessee normally should depreciate a leased asset over the

term of the lease. However, if:

(a) ownership transfers or

SALES-TYPE LEASES

On January 1, 2016, Sans Serif Publishers, Inc. leased a copier

from CompuDec Corporation at a “price” of $479,079.

T15-10

15-20 Intermediate Accounting, 8/e

LEASE PAYMENT RELATIONSHIPS

Lessor Lessee

SALES–TYPE LEASE CAPITAL LEASE

T15-11