1. Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)
Weygandt
, and
Warfield
Chapter 22: Accounting for Leases
Prepared by
Krishnan
Ranganathan
, Angelo State University,
San Angelo, Texas
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

2. Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)
Leasing: Basics
The lease is a contractual agreement between the lessor and the lessee.
The lease gives the lessee the right to use specific property
The lease specifies also the duration of the lease and rental payments
The obligations for taxes, insurance, and maintenance may be assumed by the lessor or the lessee
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

3. Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)
Advantages of Leasing
Leases may not require any money down
Lease payments are often fixed
Leases reduce the risk of obsolescence to the lessee
Leases may contain less restrictive covenants than other types of lending arrangements
Leases may be a less costly means of financing
Certain leases may not add to existing debt on the balance sheet
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

4. Conceptual Nature of a Lease
According to the FASB:
a lease transferring substantially all of the benefits and risks of ownership must be capitalized
Such a transfer is assumed, if the lease is noncancelable
Leases that do not substantially transfers benefits and risks are operating leases
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

5. Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)
Accounting by Lessee
Leases that meet any of the following four criteria are capital leases for the lessee:
Leases, transferring ownership
Leases with bargain purchase options
Leases with lease terms equal to or more than 75% of the economic life
Leases where the present value of lease payments is equal to or more than 90% of the fair market value.
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

6. Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)
Accounting by Lessee
Lease Agreement
Capital
Lease
Is there transfer
of ownership?
Yes
Is there a bargain
purchase option?
Yes No
Is lease term equal
to or greater than
75% of economic
life ?
Yes No
Is present value
of payments
equal to or more
than 90% FMV?
Yes No
Operating
Lease
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

7. The Bargain Purchase Option
A bargain purchase option
allows the lessee to buy the leased asset
at a price significantly lower than the asset’s fair value when the option is exercisable
The difference between the option price, and the fair value (when the option is exercisable)
as determined at the inception of the lease
must render the option reasonably assured
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

8. The Recovery of Investment Test (90% Test)
In determining the present value of the lease payments, three important factors are considered:
Minimum lease payments the lessee is expected to make under the lease,
Executory costs (insurance, taxes, and maintenance), and
Discount rate (used by the lessee to determine the present value of minimum lease payments)
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

9. Minimum Lease Payments
The minimum lease payments include:
minimum rental payments (which may or may not be equal to the minimum lease payments)
guaranteed residual value end of the lease term (guaranteed the lessor by the lessee or a third party)
any penalty required of the lessee for failure to extend or renew the lease
any bargain purchase option given to lessee
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

10. Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)
Accounting by Lessee
If the lease is a capital lease:
record an asset (leased equipment) and a liability (lease obligation) equal to the present value of the rental payments
record depreciation for the asset
If the lease is an operating lease:
do not record asset or liability
record rental expense as rental payments are made to lessor.
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

11. Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)
Executory Costs
If executory costs remain lessor’s responsibility, they are excluded from the minimum lease payments
If such costs are not exactly determinable, an estimate must be excluded from the lease payments
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

12. Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)
Discount Rate
The lessee computes the present value of the lease payments using the lessee’s incremental borrowing rate
If the lessee knows the lessor’s implicit interest rate and it is less than the lessee’s incremental rate, then such implicit rate must be used.
The lessor’s implicit rate produces the following result: present value of (minimum lease payments and unguaranteed residual value) = fair value of the asset to lessor
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

13. Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)
Accounting by Lessor
If the lease is a capital lease:
recognize a sale
remove the asset from books and replace it with a receivable
treat rental receipts as consisting of interest and principal
If the lease is an operating lease:
record rental income for rental receipts from lessee .
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

14. Accounting for Asset and Liability by Lessee
In a capital lease transaction, the lessee records an asset and a liability
The asset is depreciated by the lessee over the economic life of the asset
The effective interest method is used to allocate the rental payments between principal and interest
Depreciation of the asset and discharge of the lease obligation are independent accounting procedures.
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

15. Accounting by Lessor: Classification of Leases
The lessor classifies leases as:
Direct financing leases, or
Operating leases, or
Sales type leases
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

16. Accounting by Lessor: Classification of Leases
To be classified as a direct financing lease,
The lease must meet group 1 criteria (same as lessee’s), and
Collectibility of payments must be reasonably assured, and
Lessor’s performance must be substantially complete, and
Asset’s fair value must be equal to lessor’s book value
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

17. Accounting by Lessor: Classification of Leases
To be classified as an operating lease (lessor):
The lease must meet group 1 criteria (same as lessee’s), or
Collectibility of payments must reasonably assured, or
Lessor’s performance must be substantially complete.
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

18. Accounting by Lessor: Classification of Leases
To be classified as a sales type lease (by lessor):
The lease must meet group 1 criteria, and
Collectibility of payments must reasonably be assured, and
Lessor’s performance must be substantially complete, but
Asset’s fair value should not be equal to lessor’s book value
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

19. Lessor’s Criteria for Lease Classification
Lease Agreement
Does lease meet
Group 1criteria? No
Operating
Lease
Is collectibility of
payments assured? No
yes
Is lessor’s
performance
substantially
complete ? No
yes
Does asset FMV
equal lessor’s
book value? No
yes
Sales type
Direct
financing
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

20. Direct Financing: Lessor
The following information is needed by lessor to record a direct financing lease:
Gross investment (lease payments receivable), consisting of:
the minimum lease payments and
any unguaranteed residual value end of lease term
Unearned interest revenue (difference between gross investment and the FMV of the property)
Net investment (gross investment less unearned interest revenue)
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

21. Direct Financing: Lessor
Equals Fair Market Value
Cost of Asset
Gross Investment
Unearned
Revenue
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

22. Direct Financing: Lessor
The rental payments are reduced by any executory costs payable by the lessor in computing minimum payments
The unearned revenue is amortized to interest revenue by the effective interest method
The lessor reports the lease payments receivable at net (gross investment less unearned interest revenue) as “Net investment in capital leases”
Lessor records no depreciation
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

23. Operating Lease: Lessor
The lessor depreciates the leased asset according to its depreciation policy
Maintenance costs of the leased asset (payable by lessor) are charged to expense
Costs, such as finder’s fees and credit checks, are amortized over the lease term.
The leased equipment and accumulated depreciation are shown as Equipment Leased to Others.
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

24. Residual Values (General)
The residual value is the estimated fair value of the leased asset at the end of the lease term
The minimum lease payments include any guaranteed salvage value as the basis for capitalization
Any unguaranteed residual value from the lessee’s viewpoint is the same as no residual value (excluded)
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

25. Guaranteed Residual Value: Lessee
Lessee’s capitalized cost is the sum of:
the present value of annual rental payments (excluding executory costs), plus
the present value of the guaranteed residual value
At the end of the lease term:
the guaranteed residual value is equal to the obligations under the lease plus any interest payable thereon.
Any difference between the guaranteed residual value and the FMV is gain or loss to the lessee.
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

26. Unguaranteed Residual Value: Lessee
Lessee’s capitalized cost is the present value of annual rental payments (excluding executory costs)
The unguaranteed residual value is not capitalized
At the end of the lease term:
the lessee does not recognize a loss, even if the unguaranteed residual value is more than the FMV of the leased asset; or
the lessee does not recognize a gain, even if the unguaranteed residual value is less than the FMV.
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

27. Residual Value: Lessor
The net investment to be recovered by the lessor is the same whether the residual value is guaranteed or unguaranteed
The lessor assumes that the residual value will be realized at the end of the lease term
The gross investment by lessor is the sum of:
the total minimum payments under the lease, plus
the residual salvage value (guaranteed or unguaranteed)
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

28. Initial Direct Costs (Lessor)
Initial direct costs are of two types:
incremental direct costs
internal direct costs
Incremental direct costs are costs paid to independent third parties and incurred in originating a lease agreement
Internal direct costs are costs paid to lessor for specific activities performed by lessor on a given lease.
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

29. Initial Direct Costs (Lessor)
Initial direct costs are accounted for as follows:
For direct financing leases, initial direct costs are added to the net investment and amortized over the life of the lease
For sales type leases, they are expensed in the period in which profit on the sale is recognized
For operating leases, the costs are allocated over the lease term in proportion to rent income
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

30. Disclosure Requirements: Lessee
For the lessee, the requirements are:
capital leases
operating leases having initial or remaining noncancelable lease terms in excess of one year
all operating leases
a general description of the lessee’s arrangements
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

31. Disclosure Requirements: Lessor
For the lessor, the requirements are:
sales-type and direct financing leases
operating leases
a general description of the lessor’s leasing arrangements
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)

32. Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)
COPYRIGHT
Copyright © 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
11/14/2018
Intermediate Accounting, 10th Edition, Ch. 22 (Kieso et al.)