Leases

Chapter 15

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

Copyright2013byTheMcGrawHillCompanies,Inc.Allrightsreserved.

15-2

Accounting by the Lessor and Lessee

A lease is an agreement in which the
lessor conveys the right to use property,
plant, or equipment, usually for a stated
period of time, to the lessee.
Lessee
Lessee == Renter
Renter

Lessor
Lessor == Owner
Owner of
of property
property

Capital Leases and Installment Notes

Compared

Matrix, Inc. acquires equipment from Apex, Inc. by paying $193,878

every 6 months for the next 3 years. The interest rate associated
with the agreement is 9%. Lets look at the arrangement as an
installment note payable and as a capital lease agreement. First,
lets prepare an amortization schedule for the payments.

15-3

15-4

Inception of the Agreement

At inception January 1
Installment Note
Equipment
Notes payable

1,000,000

Capital Lease
Leased equipment
Lease payable

1,000,000

1,000,000

1,000,000

15-5

Classification Criteria
Operating
Lease

Capital
Lease

A capital lease must meet one of four criteria:

Ownership
Ownership transfers to
to the
the lessee
lessee at
at the
the end
end
of
of the
the lease
lease term,
term, or
or .. .. ..
A
A bargain purchase option (BPO)
(BPO) exists,
exists, or
or .. .. ..
The
The noncancelable
noncancelable lease
lease term
term is
is equal
equal to
to 75%
or more of
of the
the expected
expected economic
economic life
life of
of the
the
asset,
asset, or
or
The
The PV
PV of
of the
the minimum
minimum lease
lease payments
payments is
is
90% or more of the fair value of
of the
the asset.
asset.

15-6

Classification Criteria
Operating
Lease

Capital
Lease

A capital lease must meet one of four criteria:

Ownership transfers to
to the
the lessee
lessee at
at the
the end
end
of
of the
the lease
lease term,
term, or
or .. .. ..
A
A bargain purchase option (BPO)
(BPO) exists,
exists, or
or .. ..
..
The
The noncancelable
noncancelable lease
lease term
term is
is equal
equal to
to 75%
or more of
of the
the expected
expected economic
economic life
life of
of the
the
asset,
asset, or
or
The
The PV
PV of
of the
the minimum
minimum lease
lease payments
payments is
is 90%
or more of the fair value of
of the
the asset.
asset.

15-7

Classification Criteria
A bargain purchase option (BPO) gives the lessee the
right to purchase the leased asset at a price significantly
lower than the expected fair value of the property and the
exercise of the option appears reasonably assured.
The lease term is normally considered to be the noncancelable term of the lease plus any periods covered by
bargain renewal options. If the inception of the lease
occurs during the last 25% of an assets economic life,
this criterion does not apply.
For the lessee, a capital lease is treated as the purchase
of an asset the lessee records both an asset and
liability at inception of the lease.

15-8

Additional Lessor Conditions

The four conditions discussed apply to both the lessee
and lessor. However, the lessor must meet two
additional conditions for the lease to be classified as
either a direct financing or sales-type lease:
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.

Lessor = Owner of the property subject to the lease.

15-9

U. S. GAAP vs. IFRS

15-10

Operating Leases

Lease
Lease
agreement
agreement
exists.
exists.
Record
Record lease
lease as
as
an
an Operating
Operating
Lease.
Lease.

Criteria
Criteria for
for aa
capital
capital lease
lease
not
not met.
met.

Capital
Lease

15-11

Operating Leases
On
On January
January 1,
1, 2013,
2013, Sans
Sans Serif
Serif Publishers,
Publishers, Inc.,
Inc., aa computer
computer services
services
and
and printing
printing firm,
firm, leased
leased printing
printing equipment
equipment from
from First
First LeaseCorp.
LeaseCorp.
The
The lease
lease agreement
agreement specifies
specifies four
four annual
annual payments
payments of
of $100,000
$100,000
beginning
beginning January
January 1,
1, 2013,
2013, the
the inception
inception of
of the
the lease,
lease, and
and at
at each
each
January
January 11 thereafter
thereafter through
through 2016.The
2016.The useful
useful life
life of
of the
the equipment
equipment is
is
estimated
estimated to
to be
be six
six years.
years. Before
Before deciding
deciding to
to lease,
lease, Sans
Sans Serif
Serif
considered
considered purchasing
purchasing the
the equipment
equipment for
for its
its cash
cash price
price of
of $479,079.
$479,079. IfIf
funds
funds were
were borrowed
borrowed to
to buy
buy the
the equipment,
equipment, the
the interest
interest rate
rate would
would have
have
been
been 10%.
10%.
At the End of Four Payment Dates
San Serif Publishers, Inc. (Lessee)
Prepaid rent
100,000
Cash
100,000
First LeaseCorp (Lessor)
Cash
Unearned rent revenue

100,000
100,000

15-12

Leasehold Improvements
Sometimes a lessee will make improvements
to leased property that reverts back to the
lessor at the end of the lease. Like other
assets, leasehold improvement costs are
allocated as depreciation expense over its
useful life to the lessee, which is to be the
shorter of the physical life of the asset or the
lease term.

15-13

Capital Leases Lessee and Lessor

The amount recorded (capitalized) is the
present value of the minimum lease payments.
However, the amount recorded cannot exceed
the fair value of the leased asset.
In calculating the present value of the minimum
lease payments, the interest rate used by the
lessee is the lower of:
1. Its incremental borrowing rate, or
2. The implicit interest rate used by the lessor.

15-14

Capital Leases Lessee and Lessor

If the lessor is not a manufacturer or
dealer, the fair value of the leased
asset typically is the lessors cost.
When the lessor is a manufacturer or
dealer, the fair value of the property at the
inception of the lease is likely to be its
normal selling price.

15-15

Capital Leases Lessee and Lessor

On January 1, 2013, Sans Serif Publishers, Inc., leased printing equipment

from First Lease Corp. First Lease purchased the equipment from
CompuDec Corporation at a cost of $479,079.

The
lease agreement
specifies payments.
annual payments beginning January 1,
$479,079
$479,079 4.79079*
4.79079* == $100,000
$100,000 payments.
2013,
the
inception
and at each December 31 thereafter
*PV
annuity
due
nn ==the
6,
10%
*PV of
of an
an
annuity
due of
of $1:
$1:of
6, II ==lease,
10%
through 2017.The six year lease term ending December 31, 2018,is equal
to the estimated useful life of the
copier. 4,79079*
$100,000
$100,000
4,79079* == $479,079
$479,079 lessees
lessees cost
cost
First Lease routinely acquires electronic equipment for lease to other
firms. The interest rate In these financing arrangements is10%.

Since the lease term is equal to the expected useful life of the
equipment (>75%), the transaction must be recorded by the lessee as a
capital lease.
lease
We believe the collectibility of the lease payments is reasonably certain
and any costs to the lessor that are yet incurred are reasonably
predictable, this qualifies also as a direct financing lease to First Lease. To
achieve its objectives, First Lease must (a) recover its $479,079
investment as well as (b) earn interest revenue at a rate of 10%. So, the
lessor determined that annual rental payments would be $100,000.

15-16

Capital Leases Lessee and Lessor

Direct Financing Lease (January 1, 2013)
Sans Serif Publishers, Inc. (Lessee)
Leased equipment (PV of payments)
Lease payable (PV of payments)

479,079
479,079

First LeaseCorp. (Lessor)

Lease receivable (PV of payments)
479,079
Inventory of equipment (Lessors cost)
479,079

First Lease Payment (January 1, 2013)

Sans Serif Publishers, Inc. (Lessee)
Lease payable
Cash

100,000

First LeaseCorp. (Lessor)

Cash
Lease receivable

100,000

100,000

100,000

15-17

Capital Leases Lessee and Lessor

Amortization Schedule for the Lease

$379,079
$379,079 10%
10% == $37,908
$37,908
$100,000
$100,000 -- $37,908
$37,908 == $62,092
$62,092

$379,079
$379,079 -- $62,092
$62,092 == $316,987
$316,987

15-18

Capital Leases Lessee and Lessor

Second Lease Payment (December 31, 2013)
Sans Serif Publishers, Inc. (Lessee)
Interest expense
Lease payable
Cash
First LeaseCorp. (Lessor)
Cash
Lease receivable
Interest revenue

37,908
62,092
100,000
100,000
62,092
37,908

Depreciation Recorded at (December 31, 2013)

Sans Serif Publishers, Inc. (Lessee)
Depreciation expense
Accumulated depreciation

79,847

($479,079 6 = $79,847 Assuming straight-line method.)

79,847

15-19

Capital Leases Lessee and Lessor

Depreciation Period

The lessee normally should depreciate a

leased asset over the term of the lease.
However, if ownership transfers or a
bargain purchase option is present (i.e.,
either of the first two classification criteria
is met), the asset should be depreciated
over its useful life.

15-20

Sales-Type Leases
If the lessor is a manufacturer or dealer, the
fair value of the leased asset generally is
higher than the cost of the asset.

At
At inception
inception of
of the
the lease,
lease, the
the lessor
lessor will
will
record
record the
the cost
cost of
of goods
goods sold
sold as
as well
well as
as the
the
sales
sales revenue
revenue (PV
(PV of
of payments).
payments).

In addition to interest revenue earned over the

lease term, the lessor receives a manufacturers
or dealers profit on the sale of the asset.

15-21

Sales-Type Leases
On January 1, 2013, Sans Serif Publishers, Inc., leased
printing equipment from CompuDec Corp. at a price of
$479,079.
The lease agreement specifies annual payments of
$100,000 beginning January 1, 2013 (the inception of
the lease), and at each December 31 thereafter through
2017. The six-year lease term ending December 31,
2018, is equal to the estimated useful life of the
equipment.
CompuDec manufactured the equipment at a cost of
$300,000.
CompuDecs interest rate for financing the transaction
is10%.

15-22

Sales-Type Leases
Lease Classification
1. The lease term (6-years) is equal to 100% of the useful life of
the copier, and
2. Fair market value is different from cost of the leased asset.
3. CompuDec is certain about the collectibility of the lease
payments, and
4. No costs are to be incurred by CompuDec relating to the
lease agreement,

SO
The lease agreement is classified as a sales-type lease from the
viewpoint of CompuDec (lessor) and a capital lease from the
viewpoint of Sans Serif Publishers (lessee).

15-23

Sales-Type Leases: Lessee

At Inception of the Lease January 1, 2013
CompuDec Corp. (Lessor)
Lease receivable
Cost of goods sold
Sales revenue
Inventory of equipment

479,079
300,000
479,079
300,000

Receipt of the First Lease Payment January 1, 2013

CompuDec Corp. (Lessor)
Cash
Lease receivable

100,000
100,000

Bargain Purchase Options

and Residual Value
A bargain purchase option (BPO) is a provision of some
lease contracts that gives the lessee the option of
purchasing the leased property at a bargain price. The
expectation that the option price will be paid effectively
adds an additional cash flow to the lease for both the
lessee and the lessor. As a result:
LESSEE
LESSEE adds
adds the
the present
present value
value of
of the
the BPO
BPO price
price to
to the
the present
present value
value of
of
periodic
periodic rental
rental payments
payments when
when computing
computing the
the amount
amount to
to be
be recorded
recorded aa
leased
leased asset
asset and
and aa lease
lease liability.
liability.
LESSOR,
LESSOR, when
when computing
computing periodic
periodic rental
rental payments,
payments, subtracts
subtracts the
the present
present
value
value of
of the
the BPO
BPO price
price from
from the
the amount
amount to
to be
be recovered
recovered (fair
(fair value)
value) to
to
determine
determine the
the amount
amount that
that must
must be
be recovered
recovered from
from the
the lessee
lessee through
through the
the
periodic
periodic rental
rental payments.
payments.

15-24

15-25

Bargain Purchase Option (BPO)

On January 1, 2013, Sans Serif Publishers, Inc., leased printing equipment from
CompuDec Corporation at a price of $479,079. The lease agreement specifies
annual payments beginning January 1, 2013, the inception of the lease, and at
each December 31 there after through 2017. The estimated useful life of the
equipment is seven years. On December 31, 2018, at the end of the six-year lease
term, the equipment is expected to be worth $75,000, and Sans Serif has the
option to purchase it for $60,000 on that date. The residual value after seven years
is zero. CompuDec manufactured the equipment at a cost of $300,000 and its
interest rate for financing the transaction is10%.

15-26

Bargain Purchase Option (BPO)

Exercise of BPO at the end of the lease term:

$54,542 10% = $5,458*
$60,000 BPO payment - $5,458 = $54,542

15-27

Bargain Purchase Option (BPO)

End of Lease December 31, 2017
Sans
Sans Serif
Serif Publishers,
Publishers, Inc.
Inc. (Lessee)
(Lessee)
Depreciation
Depreciation expense
expense ($479,079
($479,079 7)
7)
Accumulated
Accumulated depreciation
depreciation
Interest
Interest expense
expense
Lease
Lease payable
payable
Cash
Cash (BPO
(BPO payment)
payment)
CompuDec
CompuDec Corporation(Lessor)
Corporation(Lessor)
Cash
Cash
Lease
Lease receivable
receivable
Interest
Interest revenue
revenue

Refer
Refer the
the amortization
amortization schedule
schedule and
and
computations
computations on
on the
the previous
previous screen
screen

68,440
68,440
5,458
5,458
54,542
54,542

60,000
60,000

68,440
68,440

60,000
60,000

54,582
54,582
5,458
5,458

15-28

Residual Value
The residual value of leased property is an estimate of what
its commercial value will be at the end of the lease term.
On January 1, 2013, Sans Serif Publishers, Inc., leased printing
equipment from CompuDec Corporation at a price of $479,079. The
lease agreement specifies annual payments beginning January 1, 2013,
the inception of the lease, and at each December 31 thereafter through
2017.The estimated useful life of the equipment is seven years. At the
end of the six-year lease term, ending December 31, 2018, the
equipment is expected to be worth $60,000. CompuDec manufactured
the equipment at a cost of $300,000 and its interest rate for financing
the transaction is10%.

15-29

Effect on the Lessee of a Residual Value

Guaranteed Residual Value
Sometimes
Sometimes the
the lease
lease agreement
agreement includes
includes aa guarantee
guarantee by
by the
the lessee
lessee
that
that the
the lessor
lessor will
will recover
recover aa specified
specified residual
residual value
value when
when custody
custody of
of
the
the asset
asset reverts
reverts back
back to
to the
the lessor
lessor at
at the
the end
end of
of the
the lease
lease term.
term. This
This
not
not only
only reduces
reduces the
the lessors
lessors risk
risk but
but also
also provides
provides incentive
incentive for
for the
the
lessee
lessee to
to exercise
exercise aa higher
higher degree
degree of
of care
care in
in maintaining
maintaining the
the leased
leased
asset
asset to
to preserve
preserve the
the residual
residual value.
value.

PV
PV factor
factor of
of an
an annuity
annuity due
due of
of $1:
$1: n=6,
n=6, i=10%
i=10%

PV
PV factor
factor of
of $1:
$1: n=6,
n=6, i=10%
i=10%

15-30

Effect on the Lessee of a Residual Value

Unguaranteed Residual Value
A lease agreement may be silent as to the question of
residual value. This is referred to as an unguaranteed
residual value. In the case of unguaranteed residual
value, the lessee is not obligated to make any payments
other than the periodic rental payments. As a result, the
present value of the minimum lease payments recorded
as a leased asset and a lease liability is simply the
present value of periodic rental payments ($445,211). The
same is true when the residual value is guaranteed by a
third-party guarantor such as an insurance company.

Effects on the Lessor of a Residual

Value
Guaranteed Residual Value
When
When the
the residual
residual value
value is
is guaranteed,
guaranteed, the
the lessor
lessor as
as well
well as
as the
the
lessee
lessee views
views itit as
as aa component
component of
of minimum
minimum lease
lease payments.
payments. In
In fact,
fact,
even
even ifif itit is
is not
not guaranteed,
guaranteed, the
the lessor
lessor still
still expects
expects to
to receive
receive itit in
in the
the
form
form of
of property,
property, or
or cash,
cash, or
or both.
both.

15-31

15-32

Residual Value Guaranteed

Lets use our previous example of a sales-type lease and replace
the bargain purchase option with a guaranteed residual value.

Sales-Type Lease January 1, 2013

Sans Serif Publishers, Inc. (Lessee)
Leased equipment
479,079
Lease payable

479,079

CompuDec Corporation (Lessor)

Lease receivable
479,079
Cost of goods sold
300,000
Sales revenue
Inventory of equipment

479,079
300,000

15-33

Residual Value Guaranteed

First Lease Payment January 1, 2013
Sans Serif Publishers, Inc. (Lessee)
Lease payable
92,931
Cash
92,931
CompuDec Corporation (Lessor)
Cash
92,931
Lease receivable
92,931

15-34

Residual Value Guaranteed

December 31, 2017
Sans Serif Publishers, Inc. (Lessee)
Depreciation expense
69,847
Accumulation depreciation
69,847
Interest expense
Lease payable
Cash

13,407
79,524
92,931

CompuDec Corporation (Lessor)

Cash
92,931
Interest revenue
13,407
Lease receivable
79,524

See amortization
schedule

15-35

Treatment of Residual Value

15-36

Executory Costs
One of the responsibilities of ownership that is
transferred to the lessee in a capital lease is the
responsibility to pay for maintenance, insurance,
taxes, and any other costs associated with
ownership. These are referred to as executory
costs.
costs
The lessee records executory costs as incurred:
Sans Serif Publishers, Inc. (Lessee)
Maintenance expense
2,000
Cash
2,000

15-37

Discount Rate
One rate is implicit in the lease agreement. This is the
effective interest rate the lease payments provide the
lessor over and above the price at which the asset is
sold under the lease. It is the desired rate of return the
lessor has in mind when deciding the size of the lease
payments. Usually the lessee is aware of the lessors
implicit rate or can infer it from the assets fair value.
When the lessors implicit rate is unknown, the lessee
should use its own incremental borrowing rate. This is
the rate the lessee would expect to pay a bank if funds
were borrowed to buy the asset.

15-38

Lessors Initial Direct Costs

Incremental costs incurred by the lessor in

negotiating and consummating a lease
agreement.
Operating Leases Capitalize and amortize
over the lease term by the lessor.
Direct Financing Leases Include as part of
investment balance.
Sales-Type Leases The initial direct costs are
expensed at the inception of the lease.

15-39

Contingent Rentals
Sometimes rental payments may be
increased (or decreased) at some
future time during the lease term,
depending on whether some
specified event occurs.
Contingent rentals are not included
in the minimum lease payments.
However, they are disclosed in the
notes to the financial statements.

15-40

Lease Disclosures
Lease disclosure requirements are quite
extensive for both the lessor and lessee.
Virtually all aspects of the lease agreement
must be disclosed. For all leases (a) a general
description of the leasing arrangement is
required as well as (b) minimum future
payments, in the aggregate and for each of the
five succeeding fiscal years.

15-41

Lease Disclosures
The lessor must disclose its net investment in
the lease. This amount is the present value of
the gross investment in the lease, which is the
total of the minimum lease payments (plus any
unguaranteed residual value).
Other required disclosures are specific to the
type of lease and include residual values,
contingent rentals, sublease rentals, and
executory costs.

Balance Sheet and

Income Statement
Lease
Lease transactions
transactions impact
impact several
several financial
financial ratios
ratios
1.
1. Debt
Debt to
to equity
equity ratio
ratio Lease
Lease liabilities
liabilities are
are
recorded.
recorded.
2.
2. Rate
Rate of
of return
return on
on assets
assets Lease
Lease assets
assets are
are
recorded.
recorded.
Whether
Whether leases
leases are
are capitalized
capitalized or
or treated
treated as
as an
an
operating
operating lease
lease affects
affects the
the income
income statement
statement and
and
balance
balance sheet.
sheet. The
The greater
greater impact
impact is
is on
on the
the
balance
balance sheet.
sheet.

15-42

15-43

Special Leasing Arrangements

1.
1.Sale-Leaseback
Sale-Leaseback Arrangements
Arrangements the
the owner
owner of
of
an
an asset
asset sells
sells itit and
and immediately
immediately leases
leases itit back
back
from
from the
the new
new owner.
owner. Any
Any gain
gain on
on the
the sale
sale of
of
the
the asset
asset is
is deferred
deferred and
and amortized.
amortized. A
A real
real loss
loss
on
on the
the sale
sale of
of the
the property
property is
is recognized
recognized
immediately.
immediately.
2.
2.Real
Real Estate
Estate Leases
Leases::

Leases
Leases of
of Land
Land Only
Only
Leases
Leases of
of Land
Land and
and Building
Building
Leases
Leases of
of Only
Only Part
Part of
of aa Building
Building

Summary of the Proposed

Lease Standard Update

15-45

Leases: Where Were Headed

The FASB and the IASB are collaborating on a joint Exposure Draft of
the new leases standard update.
Even after the proposed Accounting Standard Update (proposed
ASU) is issued, previous GAAP will be relevant until the proposed ASU
becomes effective (likely not mandatory before 2016) and students
taking the CPA or CMA exams will be responsible for the previous
GAAP until six months after that effective date. Conversely, prior to
the effective date of the proposed Accounting Standard Update it is
useful for soon-to-be graduates to have an understanding of the new
guidance on the horizon.

In the right-of-use model introduced in the proposed

standards update, all leases are recorded as an asset
and liability (with the exception of short term leases as
described later), and the concept of operating leases is
eliminated.

15-46

Right-of-Use Model

15-47

Lessee and Lessor Entries

15-48

Second Lease Payment

Effective Rate

[Dec. 31, 2013]

Outstanding
Balance

15-49

Lease Amortization Schedule

No interest yet; no
time has passed.

15-50

Amortization of the Right-of-Use Asset

(Lessee)
The

lessee amortizes its right-of-use asset over lease

term (or the useful life of the asset if its shorter).
Using the asset results in an expense for the lessee.

15-51

When the Lessor Retains a Residual Asset

On January 1, 2013, Sans Serif Publishers leased
printing equipment from First LeaseCorp who
purchased the equipment from CompuDec
Corporation at its fair value of $479,079.
Now assume
4 annual payments of $100,000 beginning January
1, 2013, and at each December 31 through 2015.
Useful life of the equipment is 6 years.
Lessor calculated payments using a rate of 10%.

15-52

When the Lessor Retains a Residual Asset

Commencement of Lease [Jan. 1, 2013]

Only a portion of the right to use the asset is being transferred. Accordingly, a
portion is being retained. The portion transferred is:

15-53

When the Lessor Retains a Residual Asset

15-54

Second Lease Payment [Dec. 31, 2013]

Outstanding Balance

Effective Rate

15-55

Lease Amortization Schedule

No interest yet; no time

has passed.

15-56

Lessee: Amortization of ROU Asset

Lessor: Accretion of the Residual Asset

The lessee incurs an expense as it uses the asset.

The lessor will record accretion of the residual asset using
the interest rate implicit in the agreement (10%).

15-57

Accretion? Why?
Consider this:
To determine the lease payments, the lessor subtracts from fair
value the present value of the four-years-away residual value:
Assets residual value at
end of 4-yr lease term

How does the lessor recover its $479,079 investment?

15-58

Accretion? Why?
So, First LeaseCorp expects to recover its $479,079 investment
as follows:

At

commencement of the lease, the lessor recorded its residual

asset at $130,394. At the end of the lease term, that amount
will have risen to $190,911. The process of increasing the
assets balance is called accretion. Since $130,394 is the PV of
$190,911 discounted at 10%, the balance (PV) will increase
annually by 10%.

15-59

Accretion? Why?
The residual asset accretes at the 10% discount rate to its
anticipated value at the end of the lease term:

First LeaseCorp earns a 10% rate of return on both the portion of its
asset transferred (interest revenue) and the portion retained as a
residual asset (accretion revenue).

Leases Effect on the Income of Lessee

And Lessor
The residual asset accretes at the 10% discount rate to its
anticipated value at the end of the lease term:

15-60

When the Lessor Earns a Profit from the

Lease

15-61

When the Lessor Earns a Profit and

Retains a Residual Asset

15-62

When the Lessor Earns a Profit and

Retains a Residual Asset

15-63

6 payments of $88,218; assets cost $300,000; FV $479,079.

The equipment is expected to have a fair value of $100,000 at
lease end.

15-64

Accretion of the Residual Asset

When there is profit in a lease, the carrying amount of the residual asset (the $35,347
portion of the equipment retained) is less than the fair value of the residual asset
($56,447). The difference ($56,447 35,347 = $21,100) is the deferred profit on
the portion of the asset not transferred.
To record accretion of the residual asset from its current fair value to its anticipated
fair value at the end of the lease term, first increase the balance of the residual asset
from its carrying amount to its current fair value at the commencement of the lease:

We also can view the deferred profit as the portion of the total profit if the equipment
were to have been transferred in its entirety minus the profit actually recognized
currently:
Total profit (479,079 300,000)
Less: Profit recognized at commencement
Deferred profit

$179,079
(157,979)
$ 21,100

15-65

Accretion of the Residual Asset

CompuDec will report a net residual asset in the balance sheet,
which is the gross residual asset offset by the deferred profit.
So, initially the reportable amount is:

But since the gross amount is accreted (increased) over the

term of the lease, the reported amount (equal to the gross
amount minus deferred profit) increases as well.

15-66

Accretion of the Residual Asset

The balance in the gross residual asset accretes at the 10%
discount rate to its anticipated value at the end of the lease term.

15-67

Accretion of the Residual Asset

To help visualize the relationship among the different ways to
measure the residual asset as of the commencement of the lease:

15-68

Summary of Lessee / Lessor Accounting

Lessee
Right-of-use asset (present value of payments) xxx
Lease liability (present value of payments)
xxx
Lessor
Lease receivable (present value of payments) xxx
Residual asset (carrying amount of portion retained, if any *)
Asset (carrying amount: derecognized) xxx
Profit

xx

(difference, if any, between the PV of lease payments

and the carrying amount transferred*)

* Carrying amount of asset x [Lease receivable /

xx

Fair value of asset]

Carrying amount of asset Amount transferred

= Amount transferred

= Residual asset

* In the rare instance that this is a debit difference, we would have a loss rather than profit. Also,
only recognize profit if it is reasonably assured. Otherwise, defer and recognize over life of
lease.

15-69

Discount Rate
In calculating the PV of the payments, the
discount rate used by the lessee is:
The rate the lessor charges the lessee
(rate that causes the sum of PV of lease
payments and the PV of the residual
value of the underlying asset to equal the
fair value of the asset today).
If the lessors rate is not known, use the
lessees incremental borrowing rate.

15-70

Initial Direct Costs

Costs associated directly with originating a
lease that would not have been incurred had
the lease agreement not occurred are.
Include legal fees, commissions, evaluating
the prospective lessees financial condition,
and preparing and processing lease
documents.
Added to the carrying amount of the right-ofuse asset if incurred by the lessee or to the
lease receivable if incurred by the lessor.

15-71

What if the Lease Term is Uncertain?

The

lease term is the non-cancellable period,

plus any options where there is a significant
economic incentive to extend or not terminate
the lease.
Factors that might create an economic
incentive for the lessee include bargain renewal
rates, penalty payments for cancellation or
non-renewal and economic penalties such as
significant customization or installment costs.

15-72

What if the Lease Payments are Uncertain?

Lease payments include:
payments that depend on an index or rate

(e.g., increase with inflation rate)

contingent

assured.

payments that are reasonably

15-73

Guaranteed Residual Value

If

a cash payment under a lessee-guaranteed

residual value is predicted, the present value of that
payment is added to the present value of the lease
payments the lessee records as both a right-of-use
asset and a lease liability.
Likewise, it also adds to the amount that the lessor
records as a lease receivable.
It is simply seen as an additional lease payment.

Short-Term Leases A Short-Cut

Method
A

lease that has a maximum possible lease term (including any options to renew) of
12 months or less is a short-term lease.

Lease-by-lease

option to choose a short-cut approach.

Lessee can elect:

not
to

to recognize a right-of-use asset or a lease liability.

recognize lease payments as expense over the lease term.

Lessor can elect:

not
to

to record the lease receivable or to derecognize the asset being leased.

recognize lease payments as revenue over the lease term.

15-74

15-75

End of Chapter 15