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Chapter 15
LEASES
© 2009 The McGraw-Hill Companies, Inc.
Slide 2
Accounting by the Lessor and Lessee
A lease is an agreement where the lessor
conveys the right to use property, plant, or
equipment, usually for a stated period of
time, to the lessee.
Lessee = Renter
Lessee
Operating lease
Capital lease
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Lessor = Owner of property
Lessor
Operating lease
Direct financing lease
Sales-type lease
© 2008 The McGraw-Hill Companies, Inc.
Slide 3
Capital Leases and Installment Notes Compared
Matrix, Inc. acquires equipment from Apex, Inc. by paying
$193,878 every six months for the next three years. The interest
rate associated with the agreement is 9%. Let’s look at the
arrangement as an installment note payable and as a capital
lease agreement. First, let’s prepare an amortization schedule
for the payments.
Date
Payment
Initial value . . . . . . . . . .
1
$ 193,878
2
193,878
3
193,878
4
193,878
5
193,878
6
193,878
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Effective
Decrease Outstanding
Interest
in Balance
Balance
.........
$ 1,000,000
$
45,000 $ 148,878
851,122
38,300
155,578
695,544
31,300
162,578
532,966
23,983
169,895
363,071
16,338
177,540
185,532
8,346
185,532
-
Slide 4
Inception of the Agreement
January 1
Installment Note
Description
Equipment
Notes payable
Debit
Credit
1,000,000
1,000,000
Capital Lease
Description
Equipment
Lease payable
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Debit
Credit
1,000,000
1,000,000
Slide 5
First Semi-Annual Payment Date
June 30
Installment Note
Description
Interest expense
Notes payable
Cash
Debit
Credit
45,000
148,878
193,878
Capital Lease
Description
Interest expense
Lease payable
Cash
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Debit
Credit
45,000
148,878
193,878
Slide 6
Lease Classification
Operating
Lease
Capital
Lease
A capital lease must meet one of four criteria:
Ownership transfers to the lessee at the end of
the lease term, or . . .
A bargain purchase option (BPO) exists, or . . .
The non-cancelable lease term is equal to
75% or more of the expected economic life of
the asset, or . . .
The PV of the minimum lease payments (MLP)
is 90% or more of the fair value of the asset.
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Slide 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 asset’s 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.
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Slide 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.
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Slide 9
Operating Leases
Lease
agreement
exists.
Record lease as
an Operating
Lease.
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Criteria for a
capital lease
not met.
Capital
Lease
Slide 10
Nonoperating Leases - Lessee
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.
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Slide 11
Nonoperating Leases - Lessor
If the lessor is not a manufacturer or
dealer, the fair value of the leased
asset is typically the lessor’s 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.
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Slide 12
Nonoperating Leases
On January 1, 2009, Matrix, Inc. signed a
5-year lease with RentPro, Inc. for
equipment. The lease specifies annual
payments of $6,000 beginning 1/1/09 and
at each December 31st through 2012.
The equipment has an economic life of 5
years and a fair value of $25,873. The
equipment reverts to RentPro at the end
of the lease. Matrix has an incremental
borrowing rate of 8%, which is the same
as the implicit rate used by RentPro to
calculate the annual payment.
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Slide 13
Nonoperating Leases - Lessee
The lease term meets the “75% of the
economic life” test.
Economic life
75% of economic life
Lease Term
Years
5
3.75
5
Lease Term (5 years) is more than 75% of the economic
life of the equipment (3.75 years). This test is met.
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Slide 14
Nonoperating Leases - Lessee
The PV of the payments  90% of the
equipment’s fair value
Minimum Lease Payments per Year
Present Value of Annuity Due factor
(5 periods @ 8%)
Present Value of the payments
Fair value of the equipment at lease inception
90% of the fair value of the equipment at
lease inception
$
×
6,000
4.31213
$ 25,872.78
$
25,873
$
23,286
The present value of the payments > 90% of the fair value of the
equipment. This test is met.
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Slide 15
Nonoperating Leases - Lessee
Matrix makes the following entries at
inception of the lease.
GENERAL JOURNAL
Date
Description
Jan 1 Leased equipment
Lease payable
Lease payable
Cash
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Debit
Credit
25,873
25,873
6,000
6,000
Slide 16
Nonoperating Leases - Lessor
In addition to the information given earlier, the
lessor (RentPro) knows that the collectibility
of the lease payments is reasonably
predictable, and there are no future costs to
be incurred. RentPro’s performance is
substantially complete as far as the lease is
concerned. RentPro is not a manufacturer
or dealer and its cost of the equipment is
$25,873 (rounded).
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Slide 17
Nonoperating Leases - Lessor
Because the cost of the asset is equal to its
fair value, the lease is classified as a Direct
Financing Lease.
GENERAL JOURNAL
Date
Description
Debit
Jan 1 Lease receivable
Inventory of equipment
25,873
Cash
Lease receivable
6,000
McGraw-Hill /Irwin
Credit
25,873
6,000
Slide 18
Lease Amortization Schedule
Period
1/1/09
1/1/09
12/31/09
12/31/10
12/31/11
12/31/12
Lease Amortization Schedule
Effective
Decrease in
Payments
Interest
Balance
$
6,000
6,000
6,000
6,000
6,000
$
$19,873 × 8% = $1,590
1,590
1,237
856
444
$
6,000
4,410
4,763
5,144
5,556
$19,873 - $4,410 = $15,463
$6,000 - $1,590 = $4,410
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Outstanding
Balance
$
25,873
19,873
15,463
10,700
5,556
0
Slide 19
Nonoperating Leases
December 31, 2009, entry by Matrix.
GENERAL JOURNAL
Date
Description
Dec 31 Interest expense
Lease obligation
Cash
Debit
Credit
1,590
4,410
6,000
December 31, 2009, entry by RentPro.
GENERAL JOURNAL
Date
Description
Dec 31 Cash
Interest revenue
Lease receivable
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Debit
Credit
6,000
1,590
4,410
Slide 20
Depreciation by Lessee
Depreciation expense is recorded in a manner
consistent with the company’s usual policy
concerning depreciation of other operational
assets.
If title passes to the lessee at the end of the lease
term, or the lease contains a bargain purchase
option, the asset is depreciated over the asset’s
economic life; otherwise, it is depreciated over the
lease term.
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Slide 21
Depreciation by Lessee
At December 31, 2009, Matrix prepares the
following entry to recognize depreciation
expense for the year.
GENERAL JOURNAL
Date
Description
Dec 31 Depreciation expense
Accumulated depreciation
$25,873
= $5,175
5 years
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Debit
Credit
5,175
5,175
Slide 22
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 inception of the lease, the lessor will
record the Cost of Goods Sold as well as the
Sales Revenue (PV of payments).
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Slide 23
Sales-Type Leases
On January 1, 2009, Matrix, Inc. signed a 5-year
lease with RentPro, Inc. for equipment. The
lease specifies annual payments of $6,000
beginning 1/1/09 and at each December 31st
through 2012.
The equipment has an economic life of 5 years
and a fair value of $25,873. The equipment
has a cost basis in the hands of RentPro of
$19,873. Title to the leased equipment passes
to Matrix at the end of the lease. Matrix has an
incremental borrowing rate of 8%, which is the
same as the implicit rate used by RentPro to
calculate the annual payment.
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Slide 24
Sales-Type Leases: Lessee
Matrix makes the following entries at
inception of the lease.
GENERAL JOURNAL
Date
Description
Jan 1 Leased equipment
Lease payable
Lease payable
Cash
McGraw-Hill /Irwin
Debit
Credit
25,873
25,873
6,000
6,000
Slide 25
Sales-Type Leases: Lessor
Because the cost of the asset is not equal to
its fair value, the lease is classified as a
Sales-Type Lease.
GENERAL JOURNAL
Date
Description
Debit
Jan 1 Lease receivable
Cost of goods sold
Sales revenue
Inventory of equipment
25,873
19,873
Cash
Lease receivable
6,000
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Credit
25,873
19,873
6,000
Slide 26
Residual Value
The residual value of a leased asset is
an estimate of what its commercial
value will be at the end of the lease
term. We need to determine the proper
accounting for residual value by both
the lessee and lessor.
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© 2008 The McGraw-Hill Companies, Inc.
Slide 27
Residual Value
Lessee Obtains Title to Leased Asset
The only impact on the lessee is the
determination of depreciation expense.
The cost of the asset will be reduced by
the estimated residual value and
depreciated over the economic life of
the asset.
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© 2008 The McGraw-Hill Companies, Inc.
Slide 28
Residual Value
Lessor Retains Title to Leased Asset
In determining the lease payment
amount, the lessor will reduce the fair
value of the asset by the present value
of the residual value. The reduced fair
value becomes the value used to
calculate the lease payments.
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© 2008 The McGraw-Hill Companies, Inc.
Slide 29
Residual Value Guaranteed by Lessee
The accounting for a direct financing lease will be
the same as without the residual value, with
two exceptions:
1. The lessee reduces the cost basis of the asset
by the guaranteed residual value to calculate
depreciation expense, and
2. If at the end of the lease term the appraised
value of the asset is less than guaranteed
amount, the lessee must pay the difference
between appraised value and guaranteed
residual value to the lessor.
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© 2008 The McGraw-Hill Companies, Inc.
Slide 30
Executory Costs
Executory costs include costs of ownership like
maintenance, insurance, taxes, and other costs. If
the lease agreement makes the lessee responsible
for the executory costs, they are treated as
expenses by the lessee.
In some cases, the lessor pays executory costs,
and the lessee will reimburse the lessor through
higher periodic lease payments. These costs are
excluded in determining the minimum lease
payment.
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© 2008 The McGraw-Hill Companies, Inc.
Slide 31
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.
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© 2008 The McGraw-Hill Companies, Inc.
Slide 32
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.
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© 2008 The McGraw-Hill Companies, Inc.
Slide 33
Lessee Disclosures
 For capital leases, disclose
◦ Gross amount of assets recorded
under capital leases.
◦ Future MLP in the aggregate and for
each of the five succeeding years.
◦ Total minimum sublease rentals to be
received in the future under noncancelable subleases.
◦ Total contingent rentals.
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© 2008 The McGraw-Hill Companies, Inc.
Slide 34
Lessee Disclosures

For operating leases in excess of one year,
disclose
◦
Future minimum rental payments required in
the aggregate and for each of the five
succeeding fiscal years.
◦ Total of minimum rentals to be received in the
future under non-cancelable subleases.

For all operating leases, disclose rental
expense, with separate amounts for
minimum rentals, contingent rentals, and
sublease rentals.
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© 2008 The McGraw-Hill Companies, Inc.
Slide 35
Lessee Disclosures
 Provide a description of the lessee’s leasing
arrangements including, but not limited to
◦ The basis on which contingent rental
payments are determined.
◦ The existence and terms of renewal or
purchase options and escalation clauses.
◦ Restrictions imposed by lease agreements
such as those concerning dividends,
additional debt, and further leasing.
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© 2008 The McGraw-Hill Companies, Inc.
Slide 36
Lessor Disclosures
 For operating leases, disclose
◦ Cost and carrying amount of property on lease
or held for leasing.
◦ Minimum future rentals on non-cancelable
leases in the aggregate and for each of the
five succeeding years.
◦ Total contingent rentals included in income.
 Provide a general description of the lessor’s
leasing arrangements.
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© 2008 The McGraw-Hill Companies, Inc.
Slide 37
Lessor Disclosures
For sales-type and direct financing leases,
disclose

◦
Components of the net investment in salestype and direct financing leases



◦
◦
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Future MLP to be received.
Unguaranteed residual values.
Unearned Interest Revenue.
Future MLP to be received for each of the
five succeeding fiscal years.
Total contingent rentals included in income.
© 2008 The McGraw-Hill Companies, Inc.
Slide 38
Balance Sheet and
Income Statement
Lease transactions impact several financial
ratios
1. Debt to equity ratio – Lease liabilities are
recorded.
2. Rate of return on assets – Lease assets are
recorded.
Whether leases are capitalized or treated as an
operating lease affects the income
statement and balance sheet. The greater
impact is on the balance sheet.
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© 2008 The McGraw-Hill Companies, Inc.
Slide 39
Special Leasing Arrangements
1. Sale-Leaseback Arrangements – the owner of an asset
sells it and immediately leases it back from the new
owner. Any gain on the sale of the asset is deferred
and amortized. A real loss on the sale of the property is
recognized immediately.
2. Real Estate Leases:
• Leases of Land Only
• Leases of Land and Building
• Leases of Only Part of a Building
3. Leveraged Leases – a third-party, long-term creditor
provides nonrecourse financing for a lease agreement
between a lessor and lessee. The lessor acquires title
to the asset after borrowing a large part of the
investment.
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© 2008 The McGraw-Hill Companies, Inc.
End of Chapter 15
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© 2008 The McGraw-Hill Companies, Inc.