Accounting for Leases. Items to be covered:. Introduction to leasing. Accounting by lessees (the party who uses the asset and has an obligation to make lease payments). Accounting by lessors (the party who owns the asset and receives lease payments).
Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.
and has an obligation to make lease payments)
receives lease payments)
Who does the leasing?
There are two main benefits that result:
This is called a “capital lease” (versus an “operating lease”) and the lessee must make the following journal entry at the inception of the lease:
However, if the lease arrangement is essentially a disguised purchase of the asset. such that substantially all risks and benefits of ownership are transferred, under GAAP the leased asset must be capitalized and obligation recorded (just like a “purchase”):
The transaction is, thus, on-balance sheet. Both the asset and the liability are initially recorded at the present value of the lease payments.
Let’s compare the two ways in which the same lease could be accounted for:
How do we know whether to account for the lease as “operating” or “capital”?
economic life of the asset?
lease payments > 90% of the fair value of the leased property?
leases were written with a provision that the lessee
could acquire the leased asset for $1 or some other
nominal amount at the maturity of the lease.
capitalization if the purchase price is significantly
lower than the asset’s expected fair market value
so that exercise is reasonably assured.
estimate the asset’s FMV to be realized when the lease
term is finished.
noncancellable term of the lease
extend the lease term when the lease is
finished. If this option is at a low enough rate
that reasonably assures extension of the lease
at maturity, then the term should include the
renewal period as well.
whether the lease renewal rate will assure
extension at some point in the future.
Payment = FMV leased asset
Chosen to provide a desired rate of return on the leased asset (like a bond yield)
Leased asset xxx
Unearned income xxxAccounting for Leases - Lessors
The lease payments receivable is equal to the total payments to be received by the lessor during the lease term, the leased asset is credited for the price the lessor paid for it and the difference between the receivable and the asset cost is unearned income.
Let’s take a look at a complete example for both the lessee and the lessor.
Read the lease accounting example.
In our previous example, had the lease qualified for treatment as an “operating” lease, the lessee would have made the following journal entries on each of the 4 lease payment dates:
The lessee would, therefore, report rent expense instead of interest and depreciation expense we recorded for the capital lease. In addition, the lessee would not have reported the leased asset and the lease liability on its balance sheet.
Over the life of the lease, the total expense reported in the lessee’s income statement would be the same under the two accounting methods. The amount of lease related expense reported in each accounting period, however, will be different:
In general, more expense is reported for capital leases in the early years of the lease life due to the increased interest expense.
This is the property and equipment section form Delta’s 1998 Annual report:
Notice that Delta reports $7.2 billion in net book value for owned assets and $299 million in net book value for leased aircraft.
Similarly, of the $5.1 billion in total long-term liabilities on Delta’s balance sheet, capitalized lease obligations amount to only $249 million.
The lease footnote indicates that most of Delta’s leases are accounted for as “operating.” Total lease payments classified as “capital” amount to $400 million while total operating lease payments amount to $15.1 billion!
If one were to compute Delta’s debt-to-equity ratio, for example, utilizing reported liabilities would underestimate the degree of financial leverage. There is a technique to adjust for the operating lease treatment, however.
Read about this adjustment for operating lease treatment in the handout.