This document discusses accounting for leases. It defines a lease and classifies leases as either finance leases or operating leases. Finance leases transfer substantially all risks and rewards of asset ownership to the lessee, while operating leases do not. The document outlines criteria for classifying a lease as a finance lease and explains accounting for finance leases by both lessees and lessors. Specifically, for finance leases lessees recognize the leased asset and liability while lessors recognize a receivable, and both are initially measured based on lease payments. For operating leases, both lessees and lessors recognize lease payments as expense or income over the lease term.
Accounting for Leases
Unit-III
Leasing Environment:
A lease is a contractual agreement between a lessor and a lessee. This arrangement gives the lessee the right to use specific property, owned by the lessor, for a specified period of time. Lessee makes the payment to the lessor in return over the lease term for the use of the property.
The largest group of leased equipment involves Information technology, Transportation (trucks, motor cars), Construction and Agriculture.
Who are the Lessors? The lessors that own this property generally fall into one of following three categories:
1. Banks.
2. Captive leasing companies.
3. Independents.
Advantages of Leasing:
1. 100% financing at Fixed Rates: Leases are often signed without initial amount from the lessee. In addition, lease payments often remain fixed which protects the lessee against inflation and increases in the cost of money.
2. Protection against Obsolescence: Leasing equipmentreduces risk of obsolescence to the lessee, and in many cases passes the risk of residual value to the lessor.
3. Flexibility: Lease agreements may contain less restrictive provisions than other debt agreements. For example, the duration of the lease may be anything from short period of time to the entire expected economic life of the asset. The payment of rent in most cases is set to enable the lessor to recover the cost of the asset plus a fair return over the life of the lease.
4. Less Costly Financing: Some companies find leasing cheaper than other forms of financing. This may reduce the tax burden of the companies. Through leasing, the leasing companies or financial institutions use these tax benefits. They can pass some of these tax benefits back to the user of the asset in the form of lower rental payments.
5. Tax Advantages: For financial reporting purposes companies do not report an asset or a liability for the lease arrangement. For tax purposes, however, companies can capitalize and depreciate the leased assets.
6. Off-Balance-Sheet Financing: Some leases do not add debt on a balance sheet or affect financial ratios. But they may be added to borrowing capacity.
Accounting by the Lessee: Lessee capitalizes a lease; it records an asset and a liability generally equal to the present value of the rental payments. Lessor having transferred substantially all the benefits and risks of ownership recognizes a sale by removing the asset from the balance sheet and replacing it with a receivable.
Capitalization Criteria (Lessee): In order to record a lease as a capital lease, the lease must be non cancelable. In addition, it must meet one or more of the following four criteria.
1. Transfers ownership to the lessee.
2. Contains a bargain purchase option.
3. Lease term is equal to or greater than 75 percent of the estimated economic life of the leased property.
4. The present value of the minimum lease payments (excluding executor costs) equals .
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1. Chapter 13
Leases
Learning Objectives
1. Differentiate between a finance lease and
an operating lease.
2. Account for finance leases by lessees and
by lessors.
3. Account for operating leases by lessees
and by lessors.
GOVT ACCTG & ACCTG FOR NPOs by:
Z.B.Millan
2. Definition of a Lease
• Lease is an agreement whereby the lessor
conveys to the lessee, in return for a payment
or series of payments, the right to use an
asset for an agreed period of time.
GOVT ACCTG & ACCTG FOR NPOs by:
Z.B.Millan
3. Classification of Leases
1. Finance lease – is a lease that transfers
substantially all the risks and rewards
incidental to ownership of an asset.
2. Operating lease – is a lease that does not
transfer substantially all the risks and
rewards incidental to ownership of an
asset.
GOVT ACCTG & ACCTG FOR NPOs by:
Z.B.Millan
4. Finance lease
Any of the following would lead to a finance lease
classification:
1. Transfer of ownership
2. Bargain purchase option
3. The lease term is for the major part of the
economic life of the asset (‘75% criterion’).
4. The present value of the minimum lease
payments is at least substantially all of the fair
value of the leased asset (‘90% criterion’).
5. The leased asset is specialized nature.
GOVT ACCTG & ACCTG FOR NPOs by:
Z.B.Millan
5. Lease of Land and Building
• The land and building elements of a lease contract are
classified separately as either operating or finance
lease.
• Lease payments are allocated based on relative fair
values.
• If no reliable allocation basis exists, the entire lease is
classified as a finance lease, unless it is clear that both
elements are operating leases.
• If the land element is immaterial, both elements are
treated as a single unit and classified as finance or
operating lease. The economic life of the buildings is
regarded as the economic life of the entire leased asset.
GOVT ACCTG & ACCTG FOR NPOs by:
Z.B.Millan
6. Inception and Commencement
• Inception of the lease – is the earlier of the date of the
lease agreement and the date of commitment by the
parties to the principal provisions of the lease. It is on
this date that:
a. A lease is classified as either an operating or a
finance lease; and
b. In the case of a finance lease, the amounts to be
recognized at the commencement of the lease
term are determined.
• Commencement of the lease term – is the date from
which the lessee is entitled to exercise its right to use
the leased asset. It is on this date that any asset or
liability resulting from the lease is initially recognized.
GOVT ACCTG & ACCTG FOR NPOs by:
Z.B.Millan
7. Accounting for Finance lease by Lessees
• At the commencement date, a lessee recognizes
the asset acquired under a finance lease and the
related lease liability measured at the lower of the:
a. fair value of the leased property at inception
date; and
b. present value of the minimum lease payments
at inception date
GOVT ACCTG & ACCTG FOR NPOs by:
Z.B.Millan
8. Minimum Lease Payments
• Minimum lease payments include the following:
1. Rentals, excluding contingent rent, costs for
services and taxes reimbursable to the lessor;
2. Bargain purchase option; and
3. Guaranteed residual value
• The MLP are discounted using the interest rate
implicit in the lease, if this is determinable; if not,
the lessee’s incremental borrowing rate is used.
• Initial direct costs are capitalized as part of the
asset recognized.
GOVT ACCTG & ACCTG FOR NPOs by:
Z.B.Millan
9. Subsequent measurement
• The lease liability is subsequently measured
at amortized cost.
• The leased asset is accounted for similar to
an owned asset. Accordingly, the leased
asset is depreciated using the entity’s
existing depreciation policies.
• If there is no reasonable certainty that the
lessee will obtain ownership by the end of
the lease term, the asset shall be
depreciated over the shorter of its useful
life and the lease term.
GOVT ACCTG & ACCTG FOR NPOs by:
Z.B.Millan
10. Accounting for Finance lease by Lessors
• A lessor recognizes the lease payments
receivable under a finance lease at an amount
equal to the net investment in the lease.
• Initial direct costs are included in the initial
measurement of the finance lease receivable
and reduce the amount of revenue recognized
over the lease term. The interest rate implicit
in the lease is defined in such a way that the
initial direct costs are included automatically in
the finance lease receivable. Therefore, there
is no need to add the initial direct costs
separately.
GOVT ACCTG & ACCTG FOR NPOs by:
Z.B.Millan
11. Interest rate implicit in the lease
• Interest rate implicit in the lease – is the
discount rate that, at the inception of the
lease, causes the aggregate present value of:
1. The minimum lease payments; and
2. The unguaranteed residual value,
to be equal to the sum of (a) the fair value of
the leased asset and (b) any initial direct costs
of the lessor.
• The lease receivable (net investment) is
subsequently measured at amortized cost.
GOVT ACCTG & ACCTG FOR NPOs by:
Z.B.Millan
12. Operating lease
• A lessee (lessor) under an operating lease
recognizes the lease payments as expense
(income) on a straight line basis over the lease
term, unless another systematic basis is more
representative of the time pattern of the user’s
benefit.
• Initial direct costs incurred by lessors are added to
the carrying amount of the leased asset and
recognized as expense over the lease term on the
same basis as the lease income.
• Initial direct costs incurred by lessees (such as
lease bonus paid to the lessor) are treated as
prepaid rent and recognized as expense on the
same basis as the lease expense.
GOVT ACCTG & ACCTG FOR NPOs by:
Z.B.Millan
