Overview

Leases

Rather than owning assets outright, sometimes organizations will lease assets from the legal owner. A lease is a legal contract in which the legal owner, or lessor,
grants the lessee the right to use an asset during a specified period of time for a specified series of payments. Depending on the terms of the contract, leases can be
classified as either finance or operating and this classification determines the method of accounting. This lesson will define the two different types of leases as well as
describe how to account for each type of lease.

Upon completion of this lesson, candidates should be able to:

Distinguish between operating and finance leases (1.A.2.t).

Recognize the correct financial statement presentation of operating and finance leases (1.A.2.u).
Study Guide
Leases

I. A lease is a legal contract in which the legal owner of an asset (the lessor) grants the counterparty to the contract (the lessee) the right to use an asset (leased
item) over a specified period of time (the lease term) for a specified series of payments (minimum lease payments). Organizations use leases to acquire the use
of various assets as an alternative to owning them outright.
A. Lessees will classify leases as one of two types:
1. Finance Lease—The lessor transfers some of the rights and benefits of ownership to the lessee.
a. A lease for a specialized piece of machinery where the lessee is responsible for repairs, insurance, or other activities traditionally considered
part of ownership is an example of a finance lease.
2. Operating Lease—The lessor transfers only the right to use the property to the lessee and the lessor/owner retains most of the risks and benefits of
ownership.
a. An apartment lease is an example of an operating lease, as the landlord pays for all repairs and other costs of ownership. In addition, the
apartment lease is generally for a relatively short period of time when compared to the life of the asset.
B. The accounting for leases is dependent upon the classification of the lease as finance or operating.
1. Finance Lease—Treat the arrangement as a borrowing and a purchase.
a. Borrowing: The lessee records a liability for the present value of the minimum lease payments and amortizes the liability as payments are
made, similar to amortizing typical mortgage debt with equal payments.
b. Purchase: The lessee records the property as a right-of-use (ROU) asset and recognizes depreciation expense on its income statement.
2. Operating Lease—The lessee records a liability for the present value of the minimum lease payments and amortizes the liability as payments are
made. An ROU asset is recorded at lease signing and the lessee amortizes the ROU asset to allow for total lease expense (interest plus ROU asset
amortization) to be recognized on a straight-line basis over the life of the lease.
II. The Financial Accounting Standards Board (FASB) has documented five criteria to determine if a lease should be recorded as a finance lease:
A. There is a transfer of ownership to the lessee at the end of the lease term.
B. There is an option to purchase the asset at a price significantly below expected market value at the end of the lease term (a “bargain purchase option”).
C. The lease term is for a major part of the remaining economic life of the underlying asset. While no bright line exists here, the FASB has given a guideline of
75% of the expected useful life of the asset when determining whether the lease term is for a “major” part of the asset's life.
D. The present value of the minimum lease payments exceeds substantially all of the fair value of the underlying asset. While no bright line exists here, the
FASB has given a guideline of 90% of the fair market value of the asset when determining whether the minimum lease payments are for “substantially all”
of the asset's value.
1. The discount rate used for the present value calculation should be:
a. The lessor's interest rate implicit in the lease (if known to the lessee), or
b. The lessee's incremental borrowing rate
E. The underlying asset is so specialized for the lessee that it is expected to have no alternative future use to the lessor at the end of the lease term.
F. Only one of the preceding five criteria must be met to record the lease as a finance lease.
III. Illustration 1: On January 1, Company A (lessor) leases a car to Company B (lessee) for 5 years with annual payments of $2,000 due at the time of signing and
annually beginning on December 31 thereafter. The useful life of the car is 10 years and there is no bargain purchase option available or automatic title transfer
to Company B at the conclusion of the lease agreement. The fair value of the car at the time of lease signing is $9,000. Company B's incremental borrowing rate
is 8% and the rate implicit in the lease is not known to Company B. The present value factor for an annuity due of $1 at 8% for 5 periods is 4.31213.
A. Lease Classification: Finance as determined specifically by the fourth criterion below.
1. Bargain purchase option? NO
2. 2 Title transfer? NO
3. 75% test? NO [5-year lease term divided by 10-year life = 50% < 75%]
4. 90% test? YES [($2,000 × 4.31213) ÷ 9,000 = 96% > 90%]
5. Specialization? NO [car]
B. A finance lease is recorded in a manner similar to purchasing the car with debt.
1. At lease signing, Company B will record the present value of the minimum lease payments as an asset on the balance sheet with a corresponding
liability. In addition, Company B will record the initial payment on the lease due at lease signing.
ROU Asset 8,624
Lease Liability 8,624
To record the lease signing.
Lease Liability 2,000

Cash 2,000
To record the initial lease payment on car lease due at lease signing.
2. At the end of each lease year, Company B will record amortization on the ROU asset similar to depreciation expense on an asset owned outright.
Amortization Expense 1,725

ROU Asset 1,725

To record the lease amortization for the first year (8,624 ÷ 5).
3. When the next lease payment is made on December 31, Company B will split the lease payment into interest expense (based on their 8%
incremental borrowing rate because the implicit rate is not known) and a reduction of the capital lease payable liability, similar to a level-payment
mortgage loan.
Interest Expense 530

Lease Liability 1,470

 Cash 2,000
To record the 2nd annual lease payment. [Interest = (8,624 − 2,000) × 8%] [Lease liability reduction = 2,000 payment − 530 interest]
4. Interest will decline for each of the next three payments as the amount of the liability decreases with each payment, similar to a level-payment
mortgage loan.

Practice Question
A Company is planning on leasing construction equipment from C Company starting on January 2, 20X8. The terms of the lease require annual
payments of $43,000 for seven years. The implicit interest rate is 11%. The first payment is due on the first day of the lease and subsequent
payments are due on December 31 of each year beginning in 20X8. The equipment has a useful life of nine years, there is no bargain purchase
option included in the contract, and the title will not transfer from C Company to A Company at the end of the lease term. The fair value of the
equipment at the time of the lease signing is $275,000.
1. Which of the five FASB lease classification criteria cause the lease to be classified as finance?
2. What is the amount of the ROU asset balance at the end of the 2nd year of the lease (after lease amortization is recorded)?
3. What is the amount of the lease liability immediately following the 3rd payment?

Answer

1. The lease would be classified as finance because it meets the 3rd criterion below:
Bargain purchase option? NO
Title transfer? NO
75% test? YES [7-year lease term divided by the 9-year life of the equipment = 78% > 75%]
90% test? NO [Divide the present value of the minimum lease payments by the fair value of the equipment. The present value of the
minimum lease payments is $224,913. $224,913 ÷ $275,000 = 82% < 90%. To find the present value of the minimum lease payments,
use the following values: Years (N): 7, Interest Rate (I): 11, Payment (P): $43,000, Solve for Present Value (PV). Make sure that your
calculator is in Begin mode because the first payment is due at the beginning of the lease term.]
Specialization? NO [construction equipment]
2. ROU Asset balance at the end of the 2nd year = $160,653. Annual Amortization Expense = Present Value of the leased equipment ÷ term of
lease = $224,913 ÷ 7 = $32,130.
3. The remaining amount for the lease liability following the 3rd payment is $133,405. The beginning of the amortization schedule is shown
below.

Payment Date Amount Interest Principal Balance

$224,913
1 January 1, 20X8 43,000 0 43,000 181,913

2 December 31, 20X8 43,000 20,010 22,990 158,923

3 December 31, 20X9 43,000 17,482 25,518 133,405

IV. Illustration 2: On January 1, Company A (lessor) leases a typical binding machine to Company B (lessee) for 5 years with annual payments of $2,000 due at the
time of signing and annually on January 1 thereafter. The useful life of the machine is 10 years and there is no bargain purchase option available or automatic
title transfer to Company B at the conclusion of the lease agreement. The fair value of the machine at the time of lease signing is $15,000. Company B's
incremental borrowing rate is 8% and the rate implicit in the lease is not known to Company B. The present value factor for an annuity due of $1 at 8% for 5
periods is 4.31213.
A. Lease Classification: Operating as determined by the criteria below.
1. Bargain purchase option? NO
2. Title transfer? NO
3. 75% test? NO [5-year lease term divided by 10-year machine life = 50% < 75%]
4. 90% test? NO [($2,000 × 4.31213) ÷ 15,000 = 57% < 90%]
5. Specialization? NO [typical binding machine]
B. The lessee must record a ROU asset and a lease liability for the present value of the minimum lease payments at lease signing. Because this is an
operating lease, lease expense will be recognized on a straight-line basis and will include both interest expense on the liability and amortization of the
ROU asset.
C. Interest in the first year is $530. [(PV $8,624 less $2,000 first advance payment) × 8%]
D. Amortization of the ROU asset in the first year is $1,470. [$2,000 annual straight-line lease expense less $530 interest]
E. Example journal entries follow.
January 1, Year 1

ROU Asset 8,624

Lease Liability 6,624

Cash 2,000
To record the lease and initial lease payment on machine lease at lease signing.
December 31, Year 1
 Lease Expense 2,000
Lease Liability 530

ROU Asset 1,470

To record first year of expense for machine lease. Interest portion: $530 [(PV $8,624 − $2,000 first advance payment) × 8%] Amortization of ROU portion:
$1,470 [$2,000 annual straight-line lease expense − $530 interest]
January 1, Year 2

Lease Liability 2,000

Cash 2,000
To record the second lease payment.
December 31, Year 2

Lease Expense 2,000

Lease Liability 412

ROU Asset 1,588
To record second year of expense for machine lease.
Interest portion: $412 [(PV $6,624 + $530 interest − $2,000 second payment) × 8%]
Amortization of ROU portion: $1,588 [$2,000 annual straight-line lease expense − $530 interest]

Practice Question
Jake Company plans to lease standard back hoe equipment on January 1, 20X4. The terms of the lease require annual payments of $15,000 for three years. The
implicit interest rate is 8% and the present value of the lease payments is $41,749. The first payment is due on January 1, 20X4 and future payments are due on
December 31. The terms of the lease do not include a bargain purchase option and the title does not transfer at the end of the lease. The equipment has a useful
life of 15 years and a fair value of $250,000 at the time of signing.

1. Using the five FASB lease classification criteria, how will this lease be classified?
2. Would your answer to the first question change if the lease agreement specifies that the lessee has the option to buy the asset for $1 at the conclusion of the
lease? Why? Why not?

Answer

1. The lease would be classified as operating because it does not meet any of the following lease criteria:
Bargain purchase option? NO
Title transfer? NO
75% test? NO [3-year lease term divided by the 15-year life of the equipment = 20% < 75%]
90% test? NO [Divide the present value of the minimum lease payments by the fair value of the equipment. The present value of minimum lease
payments = $41,749. $41,749 ÷ $250,000 = 17% < 90%]
Specialization? NO [standard back hoe]
2. The lease would be classified as finance because the lessee has the option to buy the asset for $1, a bargain, at the conclusion of the lease. This satisfies the
first lease classification criterion, and only one of the five criteria must be satisfied in order to classify the lease as finance.

Summary
A lease is a legal contract between the lessee and the lessor in which the lessee agrees to pay a specified minimum lease payment for a specified amount of time in
exchange for the right to use an asset owned by the lessor. Operating leases transfer only the right to use the asset to the lessee while the lessor retains legal
ownership. With operating leases, the lessee records a ROU asset and lease liability at lease signing. The interest on the liability and the amortization of the ROU
asset are combined and reported as lease expense on a straight-line basis each year. A finance lease transfers some of the rights and benefits of ownership to the
lessee and the arrangement is treated as a borrowing and a purchase with assets and liabilities recorded on the lessee's balance sheet. The FASB has documented
five criteria to determine if a lease should be recorded as a finance lease. It is important to understand when a lease must be recorded as a finance lease as well as
to understand the accounting for both types of leases.