CHAPTER 21
Accounting for Leases
LEARNING OBJECTIVES
1. Describe the environment related to leasing standards.
2. Explain the accountinf for leases by lessees.
CHAPTER REVIEW
1. Many businesses lease substantial portions of the property and equipment they use in their
business organization as an alternative to ownership. Because leasing provides some
financial, operating, and risk advantages over ownership, it has become the fastest growing
when leases are present.
The Leasing Environment
2. (L.O. 1) A lease is a contractual agreement between a lessor and a lessee that gives the
Advantages of Leasing
3. In discussing the advantages of leasing arrangements, advocates point out that leasing allows
4. A variety of opinions exist regarding the manner in which certain long-term lease arrange-
ments should be accounted for. These opinions range from capitalization of all long-term
leases to the belief that leases represent executory contracts that should not be
Accounting by the Lessee
5. (L.O. 2) The finance lease method is used to account for the lease. The lease liability is
6. The lease term is the fixed, non-cancelable term of the lease and may be extened by a.
Finance Leases for Lessees
7. Under the finance lease method the lessee treats the lease transaction as if an asset
were being purchased over time (installment basis). For a finance lease, the lessee records
8. Minimum lease payments include (a) minimum rental payments, (b) any guaranteed
residual value, (c) penalty for failure to renew or extend the lease, and (d) any bargain
purchase option. Minimum rental payments are the minimum payments the lessee is
9. Executory costs include the cost of insurance, maintenance, and tax expense related to
the leased asset. If the lessor makes these payments, such amounts should reduce the
present value of the minimum lease payments. When the lease agreement specifies that
10. Each lease payment is allocated between a reduction of the lease obligation and interest
expense applying the effective interest method. The lessee should depreciate the leased
asset by applying one of the conventional depreciation methods. The depreciation period
11. A complete illustration of the accounting for a finance lease by the lessee is found in the
text. It is important to understand the preparation of the Lease Amortization Schedule.
Accounting by the Lessor
12. (L.O. 3) For lessor accounting purposes, all leases may be classified as either operating
or finance leases. Finance leases are further subdivided into: (a) direct financing
leases, or (b) sales-type leases. To determine whether a lease is an operating lease or
a finance lease, the lessor uses the following criteria:
a. Does the lease transfer ownership of the asset to the lessee at the end of the lease
term?
13. The distinction between a direct financing lease and a sales-type lease is that a sales-
type lease involves manufacturer’s or dealer’s profit (or loss) and a direct financing
lease does not. The primary difference between applying the financing method to a direct
financing lease and applying it to a sales-type lease is the recognition of the manufacturer’s
Finance Lease (Lessor)
14. The lessor records increases to sales, cost of goods sold and a lease receivable, and a
decrease to inventory. The lease receivable is the present value of the minimum lease
15. Interest revenue is recognized over the lease term as lease receipts are split between
interest revenue and reduction of the lease receivable using the effective interest method.
Residual Value
16. The residual value of a leased asset is the estimated fair value of the asset at the end of
the lease term. The residual value may be guaranteed or unguaranteed by the lessee. A
17. To understand the accounting implications of a guaranteed residual value, assume a lessee
guarantees the residual value of an asset will be €8,000. If, at the end of the lease, the
fair market value of the residual value is less than €8,000, the lessee will have to record
18. Under sales-type leases, the profit recorded by the lessor at the point of sale is the same
whether the residual value is guaranteed or unguaranteed, but the sales revenue and cost
Operating Leases (Lessor)
19. Under an operating lease, the asset remains on the lessor’s books. Lease revenue is
Special Accounting Problems
20. (L.O. 4) Leases have certain characteristics that create unique accounting problems. The
next paragraphs review these characteristics.
21. Other lease adjustments include executory costs, lease prepayments and incentives and
initial direct costs. The accounting for executory costs, such as property tax and
Initial Direct Costs
22. Initial direct costs are the costs incurred by the lessor that are directly associated with
negotiating and consummating a completed leasing transaction. There are two types of
initial direct costs, incremental direct costs and internal direct costs. Incremental direct
Bargain Purchase Options
23. A bargain purchase option is a provision allowing the lessee, at his or her option, to
purchase the leased property at a price that is substantially lower than the expected fair
value of the property at the date the option becomes exercisable. When a bargain
Current versus Non-Current
24. Lease liabilities should be classified into current and non-current amounts. A common
method of measuring the current portion of the lease liability is the change–in-the-present-
Disclosure
25. The IASB requires that specific information with respect to operating leases and finance
leases be disclosed in the lessee’s financial statements, including the following:
For lessees:
• A general description of material leasing arrangements.
For lessors:
• A general description of material leasing arrangements.
*Sale-Leaseback
26. (L.O. 5) A “sale–leaseback” transaction is one in which the owner of property sells it to
another and simultaneously leases it back from the new owner. The seller-lessee, in a sale-
27. (L.O. 6) Comprehensive Example of Lease Arrangements
LECTURE OUTLINE
The material in this chapter can be covered in four class periods. Students generally are unfamiliar
A. (L.O. 1) Leases.
1. Definition: Contractual agreement between a lessor and a lessee that conveys to the
lessee the right to use specific property owned by the lessor for a specified period of time.
B. (L.O. 2) Lessees.
1. The IASB requires that all leases be capitalized unless the lease is for less than one year
or the asset is worth less than $5,000.
3. Finance Lease Method: Asset and liability recorded at PV of the minimum lease
payments.
a. Computation of minimum lease payments. Include the minimum rental payments,
guaranteed residual value, penalty for failure to renew or extend the lease, and
bargain purchase option.
D. (L.O. 3) Lessors.
1. Benefits.
2. Classification by the lessor
3. Operating Method. Rental revenue recognized as lessee uses property.
4. Finance Leases are classified as either Direct Financing Leases or Sales-Type
Leases.
a. Direct Financing Leases. Lease receivable is equal to the present value of the
minimum lease payments. Use the effective interest method to allocate each lease
payment to interest revenue and principal.
b. Sales-type Leases. Information necessary to record a sales-type lease includes:
(1) Sales Price: Present value of the minimum lease payments.
E. (L.O. 4) Special Accounting Problems.
1. Residual Values.
a. Unguaranteed versus guaranteed residual values.
b. Reasons for guaranteed residual values.
2. Initial Direct Costs: Costs incurred by the lessor associated with negotiating,
consummating, and processing the lease.
a. Operating leases: Defer such costs and allocate them over the lease term in
proportion to the recognition of rental income.
3. Bargain Purchase Options: Allows the lessee to purchase the leased property for
a future price that is much lower than the expected future fair value of the property.
Disclosure
4. Disclosure.
a. Disclosures for lessees.
F. (L.O. 5) Appendix 21-A. Sale-Leasebacks.
Sale-leaseback Transactions: The owner of property sells it to another and simultaneously
leases it back from the new owner.
2. The classification of the lease as an operating or a finance lease is done by the same