Chapter 21 Notes
Accounting for Leases
What is a lease:
A lease is a contractual agreement between a lessor and a lessee, that gives the
lessee the right to use specific property, owned by the lessor, for a specified period
of time.
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
Two types of Leases:
- Capital
- Operating
Capital Lease:
The lessee records an asset and a liability generally equal to the present value of
the rental payments.
 Records depreciation on the leased asset (over economic life of asset)
 Treats the lease payments as consisting of interest and principal.
Note: Asset and Liability are recorded at the lower of
1. PV of the minimum lease payments less executory cost or
2. FMV of the leased property
DRB notes
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FASB has identified four criteria (One or more must be met):
- Transfers ownership of the property to the lessee.
- Lease contains a bargain-purchase option.
- Lease term is equal to > 75 percent the estimated life of the leased
property.
- The PV of the minimum lease payments (excluding executory costs)*
equals or exceeds 90 percent of the fair value of the leased property.
* Minimum Lease Payments:
 Minimum rental payment (using incremental borrowing rate)
 Guaranteed residual value
 Penalty for failure to renew or extend the lease
 Bargain-purchase option
Less Executory Costs:
 Insurance
 Maintenance
 Taxes
Example: Compute present value of the minimum lease payments:
Payment
Property taxes (executory cost)
Minimum lease payment
Present value factor (i=10%,n=5)
PV of minimum lease payments
DRB notes
$ 25,981.62
- 2,000.00
23,981.62
x 4.16986
$100.000.00
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Journal entry to record accrued interest at Dec. 31, 2014.
Interest Expense
7,601.84
Interest Payable
7,601.84
Operating Lease
Lessee:
- A straight rental:
Rent Expense
Cash
25,981.62
Cash
25,981.62
25,981.62
Lessor:
Rental Revenue
DRB notes
25,981.62
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Differences using a capital lease instead of an operating lease
1. Increase in amount of reported debt.
2. Increase in amount of total assets (specifically long-lived assets).
3. Lower income early in the life of the lease.
E21-10 (Computation of Rental): Morgan Leasing Company signs an agreement on January 1,
2014, to lease equipment to Cole Company. The following information relates to this agreement.
 The term of the non-cancelable lease is 6 years with no renewal option. The
equipment has an estimated economic life of 6 years.
 The cost and fair value of the asset at January 1, 2014, is $245,000.
 The asset will revert to the lessor at the end of the lease term, at which time the asset
is expected to have a residual value of $43,622, none of which is guaranteed.
 Cole Company assumes direct responsibility for all executory costs.
 The agreement requires equal annual rental payments, beginning on January 1, 2014.
 Collectability of the lease payments is reasonably predictable. There are no important
uncertainties surrounding the amount of costs yet to be incurred by the lessor.
 Assuming the lessor desires a 10% rate of return on its investment, calculate the
amount of the annual rental payment required.
Fair market value of leased equipment
$
Present value of residual value (calculation below)
(24,623)
Amount to be recovered through lease payment
220,377
PV factor of annunity due (i=10%, n=6)
4.79079
Annual payment required
$
46,000
Residual value
$
43,622
PV of single sum (i=10%, n=6)
PV of residual value
DRB notes
245,000
0.56447
$
24,623
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b).
MORGAN LEASING COMPANY (Lessor)
Lease Amortization Schedule
Annual Lease
Payment Plus
URV
Interest (10%) on
Lease Receivable
Recovery
of Lease Receivable Lease Receivable
Date
1/1/14
1/1/14
1/1/15
1/1/16
1/1/17
1/1/18
1/1/19
12/31/19
$ 46,000
46,000
46,000
46,000
46,000
46,000
43,622
$319,622
–0–
19,900
17,290
14,419
11,261
7,787
3,965
$74,622
$
$245,000
199,000
172,900
144,190
112,609
77,870
39,657
0
$ 46,000
26,100
28,710
31,581
34,739
38,213
39,657
$245,000
c).
1/1/14
1/1/114
12/31/14
1/1/15
12/31/15
DRB notes
Lease Receivable .......................................................
Equipment .......................................................
245,000
Cash .........................................................................
Lease Receivable .............................................
46,000
Interest Receivable ....................................................
Interest Revenue ..............................................
19,900
Cash .........................................................................
Lease Receivable .............................................
Interest Receivable ..........................................
46,000
Interest Receivable ....................................................
Interest Revenue ..............................................
17,290
245,000
46,000
19,900
26,100
19,900
17,290
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Classification of Leases by the Lessor
Direct-Financing Method (Lessor)
Basically is the financing of an asset purchase by the lessee.
Lessor records:
 A lease receivable instead of a leased asset.
 Receivable is the present value of the minimum lease payments.
DRB notes
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