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Accounting for Leases. ACCTG 5120 David Plumlee. What is a Lease?. “ A lease is a contractual agreement between a lessor (owner) and a lessee (renter) that gives the lessee the right to use property owned by the lessor for a specific period of time in return for rental payments.”.

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accounting for leases

Accounting for Leases

ACCTG 5120

David Plumlee

what is a lease
What is a Lease?

“ A lease is a contractual agreement between a lessor (owner) and a lessee (renter) that gives the lessee the right to use property owned by the lessor for a specific period of time in return for rental payments.”

accounting for leases1
Before 1976 most leases accounted for leases as rental agreements. Why was this accounting found lacking ?Accounting for Leases

Over time lease agreements began to resemble installment purchases where Companies were in effect borrowing money to buy an asset

classification of leases
Classification of Leases

What is the economic nature of a capital lease?

One that transfers substantially all the risks and benefits of ownership to the lessee.

What is the economic nature of an operating lease?

One that does not transfer the risks and benefits of ownership to the lessee;a rental agreement

accounting for capital leases
Accounting for Capital Leases
  • Accounting reflects economic substance, not legal form
  • Make it appear as though company purchased an asset with borrowed funds
    • an asset and an obligation
    • interest expense on obligation
    • depreciation on asset
is this a capital lease
Does it meet ANY ONE of the four criteria?Is this a Capital Lease?
  • Lease transfers ownership of asset
    • automatically by end of lease term or
    • through a bargain purchase option
  • Lease term is at least 75% of asset’s estimated economic life
  • PV of minimum lease payments is at least 90% of asset’s fair market value at beginning of lease term
minimum lease payments
Minimum rental payments plus

Any guaranteed residual value plus

amount the lessee guarantees lessor will realize on the asset at the end of the lease term

Penalties for failure to renew lease if at the beginning of lease term renewal does not appear to be reasonably assured

Minimum Lease Payments

Leases without a BPO

mlp continued
MLP continued

What are executory costs?

Payments to the lessor to reimburse him/her for operating costs like repairs and maintenance or insurance

Are they included in MLP?


minimum lease payments1
Minimum Lease Payments

What is a bargain purchase option?

An option to purchase asset at end of lease term at a price sufficiently below expected market value that exercise of option appears reasonably assured

What is the MLP for leases with a BPO?

PV of rental payments and the BPO at the end of the lease term.

capital lease example
Capital Lease Example
  • 6-year lease
  • Annual payment due at year end = $18,287
  • No BPO and legal title does not pass at the end of lease term
  • FMV of leased asset = $75,185
  • Economic life of asset = 10 years
  • Appropriate interest rate = 12%
  • Est. salvage value = $3,185
present value of mlp



$18,287 $18,287 $18,287 $18,287

1 2 3 4 5 6

Present Value of MLP

PV = $18,287 x PVIFA(n=6, r=12%)

= $18,287 x 4.11141

= $75,185

lessee journal entries
Inception of lease: record leased asset and lease obligation at present value of MLP

Record payments

At period end accrue:

depreciate asset

record interest expense

Lessee Journal Entries
inception of lease term
JE to record leased asset and lease obligation at present value of MLP?Inception of Lease Term

leased asset $75,185

lease obligation $75, 185

depreciation expense
Depreciation Expense

On what does the depreciation period used depend?

  • If bargain purchase option exists or title passes during lease term, use economic life
  • Otherwise use lease term
basis for depreciation
Basis for Depreciation

What ending values are used for depreciation?

Salvage value if depreciating over economic life

Guaranteed residual value if depreciating over lease term

record depreciation expense
Record Depreciation Expense

What is the depreciable basis of this asset?

$75,185 (Salvage value is irrelevant because the asset reverts to the lessor.)

$75,185/6yrs = $12,531

depreciation expense $12,531

accum. depreciation $12,531

record first lease payment
interest expense ($75,185 x 12%) $9,022

lease obligation 9,265

cash $18,287

Interest rate implicit in the lease unless the lessee’s incremental borrowing rate is both known by the lessor and is lower.

Record First Lease Payment
lessor capital lease types
Lessor Capital Lease Types
  • Direct financing leases
    • PV of minimum lease payments equals the FMV of the leased asset
    • No “profit” is recorded; considered to be a financing arrangement.
  • Sales-type leases
    • PV of minimum lease payments less the FMV of the leased asset equals the “dealer profit”
    • Profit is recognized as revenue at the inception of the lease
initial direct costs
Includes costs directly associated with negotiating a particular lease

amounts paid to third parties (e.g. lawyer’s fees, appraisal fees, finders fees)

amounts incurred internally (e.g. time spent negotiating lease terms, preparing and processing documents)

Excludes indirect costs (e.g. allocated portion of general advertising, administration costs or overhead)

Initial Direct Costs
accounting for initial direct costs
Accounting forInitial Direct Costs
  • Operating -
  • Sales-type -
  • Direct financing-

defer and allocate over lease term in proportion to rental income

expense in same period as profit on sale recognized

  • add to gross investment in the lease
  • amortize over lease as a yield adjustment
example direct financing
Example - Direct Financing
  • 3 year lease
  • $20,000 payments due at end of year
  • implicit interest rate = 10%
  • FMV (lessor’s cost of asset) = $49,737
  • initial direct costs = $1,000
net investment in lease
Net Investment in Lease

What is the PV of the MLP (without initial direct costs)?

20,000 x PVIFA(n=3,r=10%)

  • $49,737 = cost (this is a direct financing lease)

Do initial direct costs affect this calculation?

Yes, they are added and a new interest rate is found.

impute new effective yield
$50,737 = $20,000 x PVa (n=3,r=?)

2.53685 = PVa (n=3,r=?)

Impute New Effective Yield

Why add to the initial direct costs?

We want the interest rate the equates the net investment to the cash flows

$49,737 = -$1,000 + $20,000 PVa (n=3,r=??)

by trial and error: r=8.89%

including initial direct costs
Including Initial Direct Costs

Reduction in income = 10,263 - 9,263

= 1,000

= initial direct costs

journal entry
Journal Entry

Entries to record lease:

deferred initial direct costs 1,000

cash (etc.) 1,000

lease receivable 60,000

unearned interest income 10,263

leased asset 49,737

journal entries
Journal Entries

Entries to record first payment and amortization of income and costs

cash 20,000

lease receivable 20,000

unearned interest income 4,974

interest income 4,974

initial direct expense amortization 463

deferred initial direct costs 463

sale leaseback

Leaseback: seller retains use of the asset


Legal title



Should the gain or loss on sale be recognized when asset “sold” to lessor?



Account for lease according to classification tests.

sale leaseback operating lease
Lessee Retains Right To Use Asset

defer gains only (losses are recognized immediately)

amortize to rent expense over lease term in proportion to rental payments

Sale/leaseback- operating lease

Why do you think we defer any gains?

Owners would strike deals where they “sold” the asset for an inflated price and booked a huge gain on sale and in return they promised to make unreasonably large lease payments in the future

sale leaseback capital lease
defer gains only (losses are recognized immediately)

amortize to depreciation expense over lease term in proportion to amortization of leased asset

Sale/leaseback -- capital lease

Lessee Retains Right To Use Asset

minor leaseback
“Minor leaseback”
  • Lessee Loses Most Rights To Use Asset
  • Defined as PV of rental payments is 10% or less of asset’s fair value
  • Recognize gain or loss on sale immediately