Lease - Accounting Chapter 15 Notes

Leases
I. Background Information
A. Parties to Lease Contract
1. Lessee Party using the property and
paying the lease payments
2. Lessor Legal owner of property who receives
the lease payments
B. Business Purpose for Lessee
1. Minimize capital resources needed
2. Tax advantages
3. Protection against obsolescence
4. Secure off-balance sheet financing
5. Avoid violating debt covenants
I. C. Types of Leases
1. Operating Lease
a. Involves mere use of property
b. Short-term in duration relative to useful life
c. Example Lease storage space on a year-to-year contract
d. Lessee Accounting
i. Record asset if prepay rent
ii. Record rent expense as incurred
iii. Asset not recorded on balance sheet
e. Lessor Accounting
i. Record liability if collect rent in advance
ii. Record rent income as earned
iii. Record depreciation on asset
I. C. Types of Leases (continued)

2. Capital Lease
a. Transfers substantially all of the benefits and
risks of ownership to Lessee
b. Is in substance similar to an installment
purchase by Lessee
c. Duration is often all (or nearly all) of assets
economic life
d. Lessee Accounting (installment purchase) i. Record leased asset as PPE
ii. Record depreciation expense on leased asset
iii. Record liability for present value of lease
payments
iv. Record interest expense related to liability
I. C. Types of Leases (continued)

2. Capital Lease (continued)
e. Lessor Accounting (installment sale) i. Remove asset from balance sheet
ii. Record receivable for lease payments
iii. Record interest income earned on outstanding
receivable
iv. If fair value of asset exceeds cost of asset
at lease inception then record gross profit
on sale of asset
I. D. Terminology
1. Executory Costs Costs associated with the
leased property including
a. Maintenance
b. Taxes
c. Insurance
Note: The lease contract will usually specify
The party responsible (bears expense)
for these costs.
The party who pays (disburses) cash for
these costs.
2. Asset Economic Life
a. Total Economic life of asset when new
b. Remaining Economic life of asset at start of
the lease
Note: If lease involves a new asset then
Total Life = Remaining Life
I.D. 3. Lease Payments

a. Payments that are set forth in the lease contract
i. Required
ii. Optional
iii. Contingent
b. Possible Components
Always Present in Contract
i. Rental Payment Payment for use of property
Sometimes Present in Contract
ii. Executory costs Payment to reimburse
lessor for executory costs that are
lessees responsibility under the
lease contract
iii. Penalty Amount Payment required by the
lease contract if the lessee does not
extend or renew the lease
iv. Purchase Option Payment lessee can make
to purchase the property
I.D.3.b. Possible Components (of lease payments)

v. Residual Value Deficiency Lease contract
may require the lessee to make up
(pay cash) any difference between
the actual value of the property at
the end of the lease and a guaranteed
value specified in the lease contract
2 types of deficiencies
Due to normal use
(treated as part of lease cost)
Due to damage, extraordinary wear
and tear, or excessive use
(treated as period cost when paid)
Note: The guaranteed value specified in the
contract may not be the full expected
residual value at the end of the lease.
In this case, part of the expected
residual value is Guaranteed
and part is Unguaranteed.
II. Classification of Lease for Lessee

A. General Issues Regarding Lessee Classification
1. To qualify as a Capital Lease some portion of
the Lease Term must be Noncancelable
2. GAAP specifies 4 tests that are designed to
indicate if a Noncancelable lease is really an
installment purchase (a capital lease)
3. Tests are applied as of lease inception
(date of lease contract)
4. If at least 1 test is met
Lease is treated as a Capital Lease
5. If none of the tests are met
Lease is treated as an Operating Lease
6. Tests 1 and 2
a. Are always reliable
b. Apply to all types of property
i. Land
ii. Buildings and Equipment
8
II.A. General Issues Regarding Lessee Classification

7. Tests 3 and 4 Not always useful
a. Land
i. Tests 3 and 4 are not useful for evaluating a
lease where land is a Material component of
the leased property
Material = More than 25% of value of leased
property
ii. So before tests 3 and 4 are used we always
check to see if the lease involves land, and if
so we calculate the value of the land relative
to the total value of the leased property
b. Buildings and Equipment
i. Tests 3 and 4 are considered unreliable if the
lease begins in the last 25% of the assets
total economic life
ii. So before tests 3 and 4 are used we always
check to be sure lease does not begin in last
25% of assets total economic life
II.A.7.b. Buildings and Equipment

iii. Example
ABC Co. leases a building with a life of 100 yrs
1
75 76
100
25 years
Lease Begins at
Start of Year
1
75
76
100
Does Lease Begin in Last

25% of Assets Total Life?
No
No Last 26%
Yes Exactly Last 25%
Yes
10
II. B. Lessee Classification Tests

1. Test 1: Does lease transfer ownership to lessee
by the end of the Lease Term ?
a. Yes = Capital Lease
b. Nominal fee may be required to cover legal
fees and taxes
2. Test 2: Does the lease contain a
Bargain Purchase Option?
b. Bargain Purchase Option
Lease contract contains an option that
permits purchase of the property at a
bargain price (below expected fair value)
and at lease inception Lessee exercise of
this option appears reasonably assured.
Note: This test really asks the following
Does the lease contain a purchase option
that seems reasonably assured of
exercise?
11

3. Test 3:
Is the following condition met?
Lease Term
75% of asset remaining

economic life at lease
inception

4. Test 4: Is the following condition met?
Present
Value
Minimum .90 x
Lease
Payments
Fair Market Value

at lease inception
FMV - ITC
Investment Tax
Credit Retained
by Lessor
12

Question: Why are tests 3 and 4 not appropriate
for land?
Answer:
To be considered a purchase in substance

the lessee must secure substantially all
of the benefits of ownership.
Since land has an unlimited life,
the Lessee must assume ownership
of the land to secure substantially all
of the benefits of ownership
(e.g. meets test 1 or test 2).
Question: Why are tests 3 and 4 not appropriate

for buildings and equipment when the
lease begins in the last 25% of the
assets total economic life?
Answer:
To be considered a purchase in substance

the lessee must secure substantially all
of the benefits of ownership.
But if the asset is in its last 25% of useful
life, the lessee does not secure
substantially all of the benefits of
ownership even though test 3 or test 4
are met.
13
II. C. Lease Term

1. Sum of the following periods
a. Fixed Noncancelable term
b. Periods covered by bargain renewal options
(bargain = renewal is reasonably assured)
c. Periods covered by a penalty for nonrenewal
where penalty appears sufficient to conclude
that renewal is reasonably assured
d. Periods covered by ordinary renewal options
during which the Lessee has guaranteed the
debt of the Lessor which is related to the
leased property
e. Periods covered by ordinary renewal options
preceding the date at which a
Bargain Purchase Option can be exercised
Note: The idea is to estimate the length of time
that we can be reasonably sure that
the lease will be in effect.
14
II.C. Lease Term (continued)

2. Noncancelable means
a. Can be canceled only upon the occurrence of
some remote contingency, or
b. Can be canceled with permission of Lessor, or
c. Can be canceled if the Lessee enters into a new
lease with the Lessor, or
d. Can be canceled if a penalty is paid, but the
penalty is of sufficient magnitude that
continuation of lease appears reasonably
assured.
3. Limit on Lease Term
Estimated Lease Term cannot exceed
the length of time from lease inception to
the date that a Bargain Purchase Option
(if any) can be exercised.
15
II.C. Lease Term (continued)

4. Example
a. Facts
Jones Co. leases equipment under a contract
with the following terms
Initial noncancelable term of 2 years
@ $100 each year
Lease can be renewed for 1 additional year
@ $60
If lease is not renewed lessee must pay
a penalty of $50
b. Lease Term
If penalty for nonrenewal is sufficient
to ensure renewal then
Lease Term = 3 years (2 + 1)
If penalty for nonrenewal is not sufficient
to ensure renewal then
Lease Term = 2 years (2 + 0)
16
II.D. Present Value of Minimum Lease Payments

1. Concept Present value of the minimum
consideration the Lessor will receive
during the course of the lease
[ abbreviated as: PV(MLP) ]
Note: Consideration can be:
o Cash payments made, and
o Guaranteed value of property
returned to Lessor
2. Components a. Consideration required under contract
i. Rent (but exclude executory costs, if any)
b. Consideration contingent on future events
and/or Lessee decisions but
reasonably assured at lease inception
i. Purchase option
ii. Penalty for nonrenewal
iii. Guaranteed residual value
17

3. Discount Rate used by Lessee
a. General Rule Use Lessee Incremental
borrowing rate
Note: Incremental Rate is the rate that Lessee
could actually secure if money were
borrowed and the asset was purchased for
cash
b. Exception Use Lessor implicit rate if
i. Known to Lessee and
ii. Lessor implicit rate < Lessee incremental rate
Note: Implicit Rate is the Lessors rate of return
earned on the leased asset.
It is also the rate that results in:
PV(MLP) + PV(UGR) = Asset Fair Value
MLP= Minimum Lease Payments
UGR= Unguaranteed Residual Value
to Lessor
18

4. Calculation Details (sum of following components)
a. PV (Net Rental Payments for Lease Term )
Net Rental = Gross Rental Executory Costs
included in
Gross Rental
b. PV (Bargain Purchase Option)
(if payment is reasonably assured)
c. PV (Penalty for Nonrenewal)
(if payment is reasonably assured)
d. PV (Guaranteed Residual Value to Lessor)
(if property expected to be returned to Lessor)
Note: Including a Bargain Purchase Option
precludes both the Penalty for Nonrenewal
and the Guaranteed Residual Value
Reason If Lessee buys the property there
is no need to renew the lease or
guarantee a residual to the Lessor
So can have: {a}, {a,b}, {a,c}, {a,d}, {a,c,d}
Cannot have: {a,b,c}, {a,b,d}, {a,b,c,d}
19

5. Example
a. Facts
Lease begins Jan. 1, 19X1
Rent =$120 each year made on Jan. 1
Rental payment includes $20 that is
reimbursement of insurance paid by Lessor
on behalf of Lessee
Lease can be renewed for 1 additional year
@ $60
If lease is not renewed lessee must pay a
penalty of $50 at end of year 2 (Dec. 31)
At lease inception Lessee does not expect to
extend lease to year 3 (so Lessee expects to
pay penalty)
Lessee Incremental Rate is 10% and
Lessors Implicit Rate is unknown
No guaranteed residual value or purchase
option
20
II.D. 5. Example (continued)

b. Lease Term = 2 years
c. Expected Lease consideration =
1
$100
Rent
$100
Rent
$50
Penalty
d. Formula to calculate present value of amount

Present Value =
Amount
(1+i)n
Amount = Amount to be paid

i = Interest rate per compounding period
n = Number of compounding periods
e. Numeric Calculation
Payment Date
1-1-X1
1-1-X2
12-31-X2
Calculation
$100 / (1.1)0
$100 / (1.1)1
$50 / (1.1)2
Total
Amount
$100.00
90.91
41.32
$232.23
21

5. Example (continued)
f. Amortization Schedule
Payment
Date
Pmt.
1-1-X1
1-1-X2
12-31-X2
Totals
$100
$100
$50
$250
Interest Principal Remaining

@10% Reduction Principal
232.23
0
100.00
132.23
13.22
86.78
45.45
4.55
45.45
0
17.77
232.23
g. Comments
i. Calculation of Lease Term affects
calculation of PV(MLP)
ii. Lease Term is based on estimates and
judgments
iii. Calculation of Lease Term and calculation of
PV(MLP) must be internally consistent
(based on same facts and assumptions)
iv. So we always calculate the Lease Term
before we calculate PV(MLP)
22
III. Journal Entries for Lessee Operating Lease

A. Pay Rent in Advance
Prepaid Rent
Cash
XX
XX
B. Adjusting Journal Entry

Rent Expense
Prepaid Rent
XX
XX
23
IV. Journal Entries for Lessee Capital Lease

A. Set-up entry at lease inception
Leased Assets Under Capital Leases
Lease Obligation [Liability]
[PPE]
XX
XX
[Liability]
Lower of: PV(MLP) or
Fair value at lease inception
Note: If asset is recorded at a lower fair value

amount, the discount rate used in the
amortization schedule is adjusted to
force the ending liability balance to 0.
Question: Does the discount rate go up
or down?
Answer: With less principal to pay, but
total payments remaining the same, this
means that the total of interest paid must
increase. Hence, the discount rate must
be increased to a higher number.
24

B. First rental payment
1. Made at start of lease period (Annuity Due),
so no interest included in the payment
Lease Obligation
[Executory Costs]
Cash
XX
XX
XX
[if any]
[Gross rental]
Debit could be to a prepaid account

or expense account depending on
the facts
25

B. First rental payment (continued)
2. Made at end of lease period (Ordinary Annuity)
(passage of time results in interest on liability)
Lease Obligation
[Executory Costs ]
Interest Expense
Cash
XX
XX
XX
XX
[if any]
[from amor. sch.]
[Gross rental]
Entry could be to Interest Payable

if interest expense has already
been accrued (see textbook)
the facts (pay in advance or after incurred
26

C. Rental payments 2, 3, ...
Lease Obligation
[Executory Costs ]
Interest Expense
Cash
XX
XX
XX
XX
[if any]
[from amor. sch.]
[Gross rental]
Entry could be to Interest Payable

if interest expense has already
been accrued (see textbook)
the facts (pay in advance or after incurred
27

D. AJE for accrued interest
Interest Expense
Interest Payable
Outstanding
Balance of
x
Lease Obligation
XX
XX
Lease
Discount
Rate
Months Int.
Accrued
12
Note: The amount of interest can also be

calculated by allocating the interest
component of the next payment as detailed
in the amortization schedule.
28

E. Year end AJE for depreciation expense
Depreciation Expense
XX
Accumulated Depreciation Leased Assets XX
Note: The calculation uses the same methods
(SL, DDB, SYD) as for regular PPE.
1. Depreciation Period
a. Lessee expects to keep asset
(lease meets tests 1 or 2)
Depreciation period = Life of asset
b. Lessee expects to return asset
(lease meets only test 3 or 4)
Depreciation period = Lease Term
29

E. Year end AJE for depreciation expense (continued)
2. Residual Value for Depreciation Calculation
a. Lessee expects to keep asset
(lease meets tests 1 or 2)
Residual = Expected value to Lessee and end of
assets useful life
Expected Value = Est. salvage at end of life
30

E. Year end AJE for depreciation expense
2. Residual Value for Depreciation Calculation
(continued)
b. Lessee expects to return asset
(lease meets only test 3 or 4)
Residual = Expected value to Lessee at end
of Lease Term
i. No Guaranteed Residual:
Expected Value = 0
ii. Guaranteed Residual:
Expected Value = Estimated Fair Value
but limited to the
Guaranteed Amount
Why? If there is a guaranteed residual the
Lessee avoids a cash payment to the
Lessor for the amount of fair value up to
the amount of the guarantee.
31

F. Exercise purchase option
1. Strategy - Remove Leased Asset accounts
Cost
Accumulated Depreciation
Set up regular Accumulated Dep.
at amount of Acc. Dep. on leased
assets
Record cash paid
Record cost of asset as plug figure
2. Example Journal Entry
At date of exercise the following GL balances exist
Leased Assets under Capital Leases 100 dr
Acc. Depreciation - Lease Assets
80 cr
Lease Obligation (Liability)
0 cr
Exercise price of purchase option is $15
Acc. Dep. - Leased Assets
80
Leased Assets - Capital Leases
100
Acc. Dep. - Equipment
80
Cash
15
Equipment
115
[plug]
32

G. Return asset to Lessor
1. Residual value guaranteed
a. Strategy: Clean off balance sheet
Leased Asset
Acc. Dep. - Lease Asset
Lease Obligation
Record interest on Lease Obligation
Record any unexpected cash
payment as a period loss
b. JE: Asset value Guarantee amount
(no deficiency cash payment required)
Interest Expense [Payable]
XX
Lease Obligation
XX
XX
XX
33

1. Residual value guaranteed (continued)
c. JE: Asset value < Guarantee amount
(deficiency cash payment required)
(record cash payment as period loss)
Interest Expense [Payable]
XX
Lease Obligation
XX
XX
XX
Loss on Capital Lease
Cash
XX
XX
34

2. Residual value not guaranteed
a. With no guarantee, at end of lease :
Leased asset cost = Acc. dep. - leased asset
Accumulated Dep. - Lease Assets
Lease Assets - Capital Leases
XX
XX
Note: With no guaranteed residual value,

the Lease Obligation balance should
be 0 after the last rental payment.
35
V. Lessee Capital Lease FS Presentation

A. Balance Sheet
1. Assets
a. Current Prepaid [executory costs]
XX
b. Noncurrent Lease Assets - Capital Leases XX

(XX)
XX
36

A. Balance Sheet
2. Liabilities
a. Current Interest Payable
Lease Obligation
XX
XX
Amount that will be retired within

next year (from amor. schedule)
b. Noncurrent Lease Obligation
XX
Amount that will be retired beyond

one year from BS date
(from amor. schedule)
37

B. Income Statement Sheet
[Executory cost] Expense
Interest Expense
XX
XX
XX
XX
[if any]
[if any]
38
VI. Classification of Lease for Lessor

A. Tests
1. Same basic rules and definitions as for Lessee
a. Transfer of ownership test
b. Bargain purchase test
c. Lease term test
d. PV(MLP) to Fair value test
Note: Lessor discount rate is always implicit rate
2. Add two additional Lessor tests related to
certainty of cash flow measurement
(both must be met)
a. Test 5: Collectibility of lease payments must be
reasonably predictable
b. Test 6: There must be no important
uncertainties regarding the amount of
unreimbursable costs yet to be incurred
by the Lessor under the lease contract
3. Lease is a capital lease for Lessor if
a. Meets at least 1 of 4 tests used by Lessees
b. Meets both tests added for Lessors
39
VI. Classification of Lease for Lessor

B. Types of capital leases (for Lessor)
1. Direct Financing a. Lessor essentially serves as financing agent
(bank).
b. Sole earnings are interest income.
c. Indicated when:
Lessor asset cost = Asset fair value
2. Sales-Type a. Lessor is a dealer/manufacturer and also
serves as financing agent (bank).
b. Earnings include:
i. Gross Profit on sale, and
ii. Interest income.
c. Indicated when:
Lessor asset cost < Asset fair value
40
VII. Journal Entries for Lessor Operating Lease

A. Collect Rent in Advance
Cash
XX
Unearned Rental Income
XX
B. Adjusting Journal Entries
1. For rent
Unearned Rental Income
Rental Income
XX
XX
2. For depreciation on asset

Accumulated Dep.
XX
XX
41
VIII. Journal Entries for Lessor Capital Lease

A. Set-up entry at lease inception (Net Method)
1. Direct Financing Lease
a. No Dealer Profit: Asset Fair Value = Asset Cost
b. Strategy -
Remove asset cost from G/L

Record receivable using net method
(gross method also permitted)
c. Entry Lease Receivable

[Asset Account]
XX
XX
[asset fair value]

[cost]
Note 1: Lease Receivable is also called the

Net Investment under net method
and equals asset FMV at lease inception
Note 2: For a Direct Financing lease
asset fair value = asset cost
(no dealer profit)
Note 3: Under net method Lease Receivable =
(1) PV(MLP) +
(2) PV(Unguaranteed Residual to Lessor)
42
VIII.A.
Note 4: If the Gross Method is used to record the
receivable the form of the entry is:
Lease Receivable
X1
[Asset Account]
X2
Unearned Interest Income
X3
[contra-asset]
In this class we will use the net method.

But old exams dated before Spring 2004
(Fall 2003 and back ) used the
Gross Method because prior editions
of the textbook used the Gross Method.
43

A. Set-up entry at lease inception
2. Sales-Type Financing Lease
a. Dealer Profit is present:
Asset Fair Value > Asset Cost
b. Strategy -
Remove asset cost from G/L

Record receivable using net method
(gross method also permitted)
Record revenue and CGS
c. Entry Lease Receivable

[Asset Account]
X1
Cost of Goods Sold

Sales Revenue
X3
X2
[ asset fair value ]

[ cost ]
X4
[ cost - PV(UGR) ]
[ PV(MLP) ]
44

B. Receive first rental payment
1. Receive at start of lease period (Annuity Due)
(no interest earned yet)
Cash
Lease Receivable
[Executory costs]
XX
XX
XX
Account credited depends on JE

Lessor made when the executory
cost was paid (expense or payable)
2. Receive at end of lease period (Ord. Annuity)

(with passage of time interest has been earned)
Cash
Lease Receivable
[Executory costs]
Interest Receivable
XX
XX
XX
XX
Could be income if interest has

not yet been accrued
45

C. Accrual of Interest Receivable and Income
Interest Receivable
Interest Income
Outstanding
Balance of
x
Lease Receivable
XX
XX
Lessor
Implicit
Rate
Months Int.
x Accrued
12
Note: This entry can be made at any time

(monthly, quarterly, year end)
46

D. Sell asset to Lessee at end of lease
1. Strategy -
Remove any remaining Lease Rec.

Record Interest (if any)
Record receipt of Cash
Balancing amount (if any) is gain/loss
2. Comment regarding Lease Receivable

After last rental payment the balance will be:
Lease
Lessor Expectation at Lease Inception Receivable
About Leased Asset
Balance
Property expected to be returned to
0
Lessor and estimated residual value=0
PV(XX) at
Lessor and estimated residual value=XX
start of
(guaranteed or unguaranteed)
last year
Property not expected to be returned to
Lessor and no payment to be made by
0
Lessee (automatic title transfer)
PV(YY) at
Lessor and payment to be made by
start of
Lessee=YY (cash purchase option)
last year
47
VIII.D. Sell asset (continued)

3. Example #1
a. Facts
on behalf of Lessee
Lessee can purchase asset at end of year 2
for $50
At lease inception Lessor expects Lessee to
exercise the purchase option
Lessors implicit rate is 10%
(asset fair value=$232.23)
Expected residual value to Lessor is 0
because Lessor expects Lessee to purchase
the asset (asset is expected to have a fair
value of $60 at end of lease)
48
VIII.D. 3. Example JE (continued)

b. Lessor Amortization Schedule
Net
Pmt.
Interest Receivable Remaining

Date
@10% Recovered Receivable
232.23
1-1-X1
$100
0
100.00
132.23
1-1-X2
$100
13.22
86.78
45.45
12-31-X2
$50
4.55
45.45
0
purchase
price
c. Sale journal entry at 12-31-X2 (as expected)
Cash
Lease Receivable
Interest Income
50.00
45.45
4.55
49
VIII.D. Sell Asset (continued)

4. Example #2
a. Facts
on behalf of Lessee
for $50
At lease inception Lessor does not expect
Lessee to exercise the purchase option
(asset fair value =$240.49)
Expected residual value to Lessor is $60
and this is not guaranteed by Lessee
50
VIII.D. 3. Example Sale JE (continued)

Net
Pmt.

Date
240.49
1-1-X1
$100
0
100.00
140.49
1-1-X2
$100
14.05
85.95
54.54
12-31-X2
$60
5.46
54.54
0
expected
residual
c. Sale journal entry at 12-31-X2 (not expected)
Cash
Lease Receivable
Interest Income
Loss on Sale of Leased Asset
50.00
54.54
5.46
10.00
51
VIII. E. Lessee returns asset at end of lease

1. Strategy -
Remove any remaining Lease Rec.

Record Interest (if any)
Record receipt of returned asset
Balancing debit (if any) is loss (no
gain recorded)
2. Comment regarding: Lease Receivable

After last rental payment the balance will be:
Lease
Lessor Expectation at Lease Inception Receivable
About Leased Asset
Balance
0
Lessor and estimated residual value=0
PV(XX) at
Lessor and estimated residual value=XX
start of
(guaranteed or unguaranteed)
last year
Lessor and no payment to be made by
0
Lessee (automatic title transfer)
PV(YY) at
Lessor and payment to be made by
start of
Lessee=YY (cash purchase option)
last year
52
VIII.E. JE for return of assed (continued)

3. Example #1 (return expected)
a. Facts
on behalf of Lessee
for $50
At lease inception Lessor does not expect
Lessee to exercise the purchase option
Expected residual value to Lessor is $60
and this is not guaranteed by Lessee
53
VIII.E. 3. Example Return JE (continued)

Net
Pmt.

Date
240.49
1-1-X1
$100
0
100.00
140.49
1-1-X2
$100
14.05
85.95
54.54
12-31-X2
$60
5.46
54.54
0
expected
residual
c. Return journal entry at 12-31-X2
(Asset returned as expected)
(Asset fair value $60 as expected)
Inventory
Lease Receivable
Interest Income
60.00
54.54
5.46
54
VIII.E. Example Return JE (continued)

4. Example #2: Use same facts as example #1 but
assume fair value = $40
(Asset fair value less than expected and
residual value not guaranteed by Lessee)
Inventory
Lease Receivable
Interest Income
40.00
54.54
5.46
20.00
55

5. Example #3: Use same facts as example #1 but
assume asset fair value = $40 and
residual of $60 is guaranteed by
Lessee
(Asset fair value less than expected and
residual value is guaranteed by Lessee)
(Lessee makes $20 residual deficiency payment)
Inventory
Lease Receivable
Interest Income
Cash
40.00
54.54
5.46
20.00
56

6. Example #4 (return not expected)
a. Facts
on behalf of Lessee
for $50
At lease inception Lessor expects Lessee to
exercise the purchase option
Expected residual value to Lessor is 0
because Lessor expects Lessee to purchase
the asset (asset is expected to have a fair
value of $60 at end of lease)
57
VIII.E. 6. Example JE (continued)

Net
Pmt.

Date
232.23
1-1-X1
$100
0
100.00
132.23
1-1-X2
$100
13.22
86.78
45.45
12-31-X2
$50
4.55
45.45
0
purchase
price
c. Return journal entry at 12-31-X2
(Return not expected)
(Asset fair value = $60 as expected)
Inventory
50.00
Lease Receivable
45.45
Interest Income
4.55
Note: Recognition of any apparent gain
is deferred until confirmed by an
arms-length transaction
58
VIII.E.
7. Example #5 (return not expected)
a. Use same facts as Example #4 but now assume
the leased asset has a fair value of $40
b. Return journal entry at 12-31-X2
(Return not expected)
(Asset fair value = $40 not as expected)
(Residual not guaranteed)
Inventory
40.00
Lease Receivable
45.45
Interest Income
4.55
Loss on Capital Lease 10.00
59
IX. Lessor Capital Lease FS Presentation

A. Balance Sheet
1. Assets
a. Current Interest Receivable
Lease Receivable
XX
XX
Amount that will be collected

within next year per amor. schedule
b. Noncurrent Lease Receivable
XX
Amount that will be collected beyond

one year from BS date per amor. schedule
2. Liabilities - None
60
IX. Lessor Capital Lease FS Presentation

B. Income Statement Sheet
Sales Revenue
Cost of Goods Sold
Interest Income (Revenue)
XX
(XX)
XX
XX
Sales-Type
Lease
[if any]
61
X. Leases Involving Land

A. General Concepts
1. If Land is immaterial part of leased asset we
ignore the fact that land is present
Material 25% of leased property value at
lease inception
2. If Land is material, we separate land from other
part of property, then account for each part of
leased property separately
Lease of land can be a capital lease only if
Test 1 or Test 2 is met
So Lessee must be expected to become
legal owner of the land
62

B. Land only
1. Lessee
a. Capital lease if: Test 1 or Test 2 is met
(Lessee expected to get land)
b. Otherwise an operating lease
2. Lessor
a. Capital lease if: Test 1 or Test 2 is met, and
both Tests 5 and 6 are met
b. Otherwise and operating lease
63

C. Land and Buildings
1. Land value < 25% of value of leased property
Ignore fact that lease involves land and
use normal tests (1-4 for lessee; 1-6 for lessor)
and normal journal entries
2. Land value 25% of value of leased property
a. Allocate lease payment between
land component and building component
b. Land component must meet either Test 1 or
Test 2 to qualify as a capital lease
c. Apply normal tests to building component
(tests 1-4 for lessee; tests 1-6 for lessor)
Note: This means that in some leases the
land component is an operating lease and
the building component is a capital lease
64
XI. Lessor Treatment of Initial Direct Costs

A. Definition - Direct costs incurred in securing a
specific lease.
Examples: Brokers fees
Appraisal costs
Credit check costs
Labor cost of negotiating lease
B. Accounting Treatment
1. Operating Lease a. Defer and allocate to expense over the lease
term
b. Basis of allocation is proportion of rental
income recorded (to get proper matching)
2. Sales-Type Lease Expense in year lease starts
(to match with profit on sale)
3. Direct Financing Lease Add cost to net investment (LR) and amortize
as a yield (interest income) adjustment
65
Remember
Old exams before Spring 2004 use the
Gross Method to report the Lessors
lease receivable.
The current edition of the book uses
the Net Method to report the Lessors
lease receivable.
Your exam will assume use of the
Net Method to be consistent with the
textbook.
66

Lease - Accounting Chapter 15 Notes

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Lease - Accounting Chapter 15 Notes

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Leases

I. C. Types of Leases (continued)

I. C. Types of Leases (continued)

I.D. 3. Lease Payments

I.D.3.b. Possible Components (of lease payments)

II. Classification of Lease for Lessee

II.A. General Issues Regarding Lessee Classification

II.A.7.b. Buildings and Equipment

Does Lease Begin in Last

II. B. Lessee Classification Tests

II. B. Lessee Classification Tests

Is the following condition met?

75% of asset remaining

a. Yes = Capital Lease

Fair Market Value

a. Yes = Capital Lease

II. B. Lessee Classification Tests

To be considered a purchase in substance

Question: Why are tests 3 and 4 not appropriate

To be considered a purchase in substance

II. C. Lease Term

II.C. Lease Term (continued)

II.C. Lease Term (continued)

II.D. Present Value of Minimum Lease Payments

II.D. Present Value of Minimum Lease Payments

II.D. Present Value of Minimum Lease Payments

II.D. Present Value of Minimum Lease Payments

II.D. 5. Example (continued)

d. Formula to calculate present value of amount

Amount = Amount to be paid

II.D. Present Value of Minimum Lease Payments

Interest Principal Remaining

III. Journal Entries for Lessee Operating Lease

B. Adjusting Journal Entry

IV. Journal Entries for Lessee Capital Lease

Note: If asset is recorded at a lower fair value

IV. Journal Entries for Lessee Capital Lease

Debit could be to a prepaid account

IV. Journal Entries for Lessee Capital Lease

Entry could be to Interest Payable

IV. Journal Entries for Lessee Capital Lease

Entry could be to Interest Payable

IV. Journal Entries for Lessee Capital Lease

Note: The amount of interest can also be

IV. Journal Entries for Lessee Capital Lease

IV. Journal Entries for Lessee Capital Lease

IV. Journal Entries for Lessee Capital Lease

IV. Journal Entries for Lessee Capital Lease

IV. Journal Entries for Lessee Capital Lease

IV. Journal Entries for Lessee Capital Lease

IV. Journal Entries for Lessee Capital Lease

Note: With no guaranteed residual value,

V. Lessee Capital Lease FS Presentation

b. Noncurrent Lease Assets - Capital Leases XX

V. Lessee Capital Lease FS Presentation

Amount that will be retired within

Amount that will be retired beyond

V. Lessee Capital Lease FS Presentation

VI. Classification of Lease for Lessor

VI. Classification of Lease for Lessor

VII. Journal Entries for Lessor Operating Lease

2. For depreciation on asset

VIII. Journal Entries for Lessor Capital Lease