Lease
Lease
Lease
Advantages of Leasing
1. 100% financing at fixed rates.
2. Protection against obsolescence.
3. Flexibility.
4. Less costly financing.
5. Tax advantages.
6. Off-balance-sheet
financing.
THE LEASING ENVIRONMENT
Leases that DO NOT meet any of the four criteria are accounted for
as operating leases.
ACCOUNTING BY THE LESSEE
Capitalization Criteria
Transfer of Ownership Test
If the lease transfers ownership of the asset to the lessee, it is a
finance lease.
Capitalization Criteria
Economic Life Test
Lease term is generally considered to be the fixed, non-
cancelable term of the lease.
Bargain-renewal option can extend this period.
At the inception of the lease, the difference between the
renewal rental and the expected fair rental must be great
enough to make exercise of the option to renew reasonably
assured.
ACCOUNTING BY THE LESSEE
Capitalization Criteria
Recovery of Investment Test
Minimum Lease Payments:
Minimum rental payments
Guaranteed residual value
Penalty for failure to renew or extend the lease
Bargain-purchase option
Executory Costs:
Insurance Exclude from PV of
Maintenance Minimum Lease
Taxes Payment Calculation
ACCOUNTING BY THE LESSEE
Capitalization Criteria
Recovery of Investment Test
Discount Rate
Lessee computes the present value of the minimum lease
payments using the implicit interest rate.
In the event it is impracticable to determine the implicit rate, the
lessee should use its incremental borrowing rate.
ACCOUNTING BY THE LESSEE
Depreciation Concept
Depreciation and the discharge of the obligation are independent
accounting processes.
ACCOUNTING BY THE LESSEE
Illustration: CNH Capital (NLD) (a subsidiary of CNH Global) and Ivanhoe Mines Ltd.
(CAN) sign a lease agreement dated January 1, 2015, that calls for CNH to lease a front-
end loader to Ivanhoe beginning January 1, 2015. The terms and provisions of the lease
agreement and other pertinent data are as follows.
• The term of the lease is five years. The lease agreement is non-cancelable, requiring
equal rental payments of $25,981.62 at the beginning of each year (annuity-due
basis).
• The loader has a fair value at the inception of the lease of $100,000, an estimated
economic life of five years, and no residual value.
• Ivanhoe pays all of the executory costs directly to third parties except for the
property taxes of $2,000 per year, which is included as part of its annual payments to
CNH.
• The lease contains no renewal options. The loader reverts to CNH at the termination
of the lease.
• Ivanhoe’s incremental borrowing rate is 11 percent per year.
• Ivanhoe depreciates similar equipment that it owns on a straight-line basis.
• CNH sets the annual rental to earn a rate of return on its investment of 10 percent per
year; Ivanhoe knows this fact.
ACCOUNTING BY THE LESSEE
Payment $ 25,981.62
Property taxes (executory cost) - 2,000.00
Minimum lease payment 23,981.62
Present value factor (i=10%,n=5) x 4.16986 *
Ivanhoe uses CNH’s implicit interest rate of 10 percent instead of its incremental
borrowing rate of 11 percent because (1) it is lower and (2) it knows about it.
Ivanhoe records the finance lease on its books on January 1, 2015, as:
Prepare the required on December 31, 2015, to record depreciation for the
year using the straight-line method ($100,000 ÷ 5 years).
Ivanhoe records
the lease
payment of
January 1,
2015, as
follows.
Economics of Leasing
A lessor determines the amount of the rental, basing it on the rate of
return—the implicit rate—needed to justify leasing the asset.
b. Finance leases
Direct-financing leases
Sales-type leases
ACCOUNTING BY THE LESSOR
We repeat here the information relevant to CNH in accounting for this lease
transaction.
4. The lease contains no renewal options. The equipment reverts to CNH at
the termination of the lease.
5. CNH sets the annual lease payments to ensure a rate of return of 10
percent (implicit rate) on its investment as shown.
CNH records the lease of the asset and the resulting receivable on
January 1, 2015 (the inception of the lease), as follows.
On January 1, 2015, CNH records receipt of the first year’s lease payment as
follows.
Cash 25,981.62
Ivanhoe records accrued interest on December 31, 2014
Lease Receivable 23,981.62
Property Tax Expense/Property Taxes Payable 2,000.00
ACCOUNTING BY THE LESSOR
On December 31, 2015, CNH recognizes the interest revenue earned during
the first year through the following entry.
At December 31, 2015, CNH reports the lease receivable in its statement of
financial position among current assets or non-current assets, or both. It
classifies the portion due within one year or the operating cycle, whichever is
longer, as a current asset, and the rest with non-current assets.
ACCOUNTING BY THE LESSOR
The following entry records the receipt of the second year's lease payment on
January 1, 2016.
Cash 25,981.62
Ivanhoe records accrued interest on16,379.78
Lease Receivable
December 31, 2014
Interest Receivable 7,601.84
Property Tax Expense/Property Taxes Payable 2,000.00
ACCOUNTING BY THE LESSOR
Interest Receivable
Ivanhoe 5,963.86
records accrued interest on December 31, 2014
Interest Revenue 5,963.86
ACCOUNTING BY THE LESSOR
Assuming that the direct-financing lease illustrated for CNH does not
qualify as a finance lease, CNH accounts for it as an operating lease and
records the cash rental receipt as follows.
Cash 25,981.62
Rental Revenue 25,981.62
1. Residual values.
2. Sales-type leases (lessor).
3. Bargain-purchase options.
4. Initial direct costs.
5. Current versus non-current classification.
6. Disclosure.
SPECIAL ACCOUNTING PROBLEMS
Residual Values
Meaning of Residual Value - Estimated fair value of the leased asset
at the end of the lease term.
Residual Values
Lease Payments - Lessor may adjust lease payments because of the
increased certainty of recovery of a guaranteed residual value.
At the end of the lease term, before the lessee transfers the asset to CNH,
the lease asset and liability accounts have the following balances.
Assume that Ivanhoe depreciated the leased asset down to its residual
value of $5,000 but that the fair market value of the residual value at
December 31, 2019, was $3,000. Ivanhoe would make the following
journal entry.
Guaranteed Residual Value (Lessee)
ILLUSTRATION 21-20
Lease Amortization Schedule for Lessee
—Unguaranteed Residual Value
Unguaranteed Residual Value (Lessee)
At the end of the lease term, before Ivanhoe transfers the asset to CNH,
the lease asset and liability accounts have the following balances.
Lessee Entries Involving Residual Values
SPECIAL ACCOUNTING PROBLEMS
CNH would
make the
following
entry for this
direct-
financing
lease on
1/1/15.
CNH would
make the
following
entry for this
direct-
financing
lease on
1/1/15.
Cash 25,237.09
Lease Receivable 23,237.09
Property Tax Expense/Property Taxes Payable
2,000.00
Lessor Accounting for Residual Value
CNH would
make the
following
entry for this
direct-
financing
lease on
12/31/15.
SALES PRICE OF THE ASSET. The present value of the minimum lease
payments.
COST OF GOODS SOLD. The cost of the asset to the lessor, less the present
value of any unguaranteed residual value.
Sales-Type Leases (Lessor)
The total of future minimum lease payments at the end of the reporting
period, and their present value for periods (1) not later than one year,
(2) later than one year and not later than five years, and (3) later than
five years.
SPECIAL ACCOUNTING PROBLEMS
The gross investment in the lease and the present value of minimum
lease payments receivable at the end of the reporting period for periods
(1) not later than one year, (2) later than one year and not later than
five years, and (3) later than five years.
Unresolved Lease Accounting Problems