The standard for accounting for leases is found in FASB 13.

Key Definitions in Leasing

The lessor is the one who owns the property (examples: medical equipment, computer equipment, manufacturing equipment, or real estate) being leased out. The lessor receives the rent. (One easy way to remember which is which: Owner = LessOr!) The lessee is the one who is using the property and pays the rent. The residual value represents an estimate of what the property being leased will be worth at the end of the lease term. This is a key concept in leasing and in lease accounting. Reflect on how the residual value will vary depending on whether an asset being leased quickly becomes obsolete (like computer hardware does) or retains much of its value over time, or even ends up appreciating, such as real estate. The lessor's implicit interest rate is the rate of return that the lessor uses in computing the rent that it will be charging over the lease term. The lessee's incremental borrowing rate is the interest rate that the lessee would be required to pay over the lease term if it obtained outside financing of the property being leased.

Accounting Possibilities to the Lessee and to the Lessor The lessee has two accounting possibilities. 1. Under operating lease accounting, the lessee books neither the equipment leased nor a debt obligation. The lessee just records the rent paid as rental expense on its income statement. There is one interesting twist here. The FASB requires the rent expense to be booked over the lease period based upon the benefit derived from the use of the asset being leased. In practice, this usually means the same amount of rent expense being recorded each year over the lease term, even though the rent paid is in uneven amounts (usually stepped up) over the lease term. 2. Under capital lease accounting, at the inception of the lease, the lessee records both an asset and a debt (liability) on its balance sheet, just as if it had purchased the equipment. Thus the balance sheet is grossed up. On the lessee's income statement, there is no rental expense; however, the interest portion of the rental payments is booked as interest expense in the income statement. The principal portion of the rental payment is recorded as a reduction of the lease debt on the balance sheet. Further, the equipment is depreciated by the lessee and thus the income statement also includes a depreciation expense charge. (This is very similar to recording a mortgage payment.) The lessor has three accounting possibilities. 1. Under operating lease accounting, the lessor (who owns the equipment being leased out) records rental income for the lease payments received.

In addition, the equipment is depreciated, and thus the income statement includes a depreciation expense charge. Then on the balance sheet, there is a clear description of assets under operating lease. 2. Under direct financing lease accounting, at the inception of the lease, the lessor switches the hard asset (equipment) on its books to a soft asset (a lease receivable or officially called its "net investment in a direct financing lease"). Its income statement will not show rental income for this lease, but instead will show interest income for the portion of the rental payments received that represent interest. 3. Under sales-type lease accounting, at the inception of the lease, the lessor marks up the hard asset (inventory) and records a gross profit for the excess of sales price over the cost of the inventory. Thus, its income statement includes both sales revenue and cost of goods sold expense. Further, just as in the case of direct financing lease accounting, the income statement will not include rental income but will instead include interest income for the portion of the rental payments received that represent interest. Then on the balance sheet, the lessor would have a lease receivable officially called "net investment in sales-type leases." How to Decide the Proper Lease Accounting The FASB has issued rules for determining the appropriate accounting for leases. The FASB's Group I and Group II lease capitalization criteria are both shown in detail below. The lessee needs to focus on only the Group I capitalization criteria; however, the lessor needs to consider both the Group I and the Group II lease capitalization criteria. The lessee's accounting is straightforwardif the lease meets one or more of the Group I criteria, then the lessee has a capital lease. On the other hand, if the lessee meets none of the Group I criteria, then it has an operating lease. The Group I criteria are evaluated as follows, and only one of them has to be met in order to record a capital lease.

For the lessor, treating a lease as capital requires two steps. Once one of the above Group I criteria has been met, the lessor must meet one of the following Group II criteria. Group II 1. It is reasonably predictable as to the collectibility of the payments required from the lessee. 2. There are no important uncertainties surrounding the amount of unreimbursable costs yet to be incurred by the lessor under the lease. The lessor's performance is also substantially complete or future costs are reasonably predictable. To make sure you have mastered whether the lessee has an operating lease or a capital lease, let's try this one. Noncancelable Lease A: Does not transfer ownership to the lessee Has a purchase option at fair market value Has a lease term of 5 years with the option to lease for another 3 years at market rental rates The economic life of the equipment being leased is 8 years The minimum lease payments are equal to 90% of the value of the equipment being leased Do you think this lease should be capitalized by the lessee? Well, you have to be very careful about the wording, don't you? Clearly, you don't meet Criterion 1. But what about Criteria 2, 3, and 4? You don't meet Criterion 2, because there is no bargain purchase option. On Criterion 3, you want to include only the noncancelable lease life unless there are bargain lease rental periods (which there are not) and thus the lease life would be 5/8 or 62.5% of the economic life of the equipment being leased. Thus,

Criterion 3 is not met. Lastly, Criterion 4 is not met, because the test is on the present value of minimum lease payments, which have to be lower than the minimum lease payments, which are only 90% of the fair value of the property being leased. The end result is that you should have concluded that Lease A is not a capital lease. This exercise is worked through by companies all the time, and there is so much effort placed in the avoidance of lease capitalization by skirting each of the four criteria. Most of the time, the focus is on Criterion 4 because it is the toughest to avoid, because the lessor logically is going to want to get as much rent as it can. The higher the rent in the lease agreement, the higher the present value of minimum lease payments. It could well be that the FASB will eventually revisit FAS 13 and its many subsequent pronouncements on lease accounting. What has happened is that the overwhelming majority of leases have been treated as operating leases by lessee companies by just skirting the lease capitalization rules. (These issues are some of the primary reasons that the FASB and IASB are working to revise lease rules with the convergence project.) The mental gymnastics for determining the proper accounting by the lessor are much more intricate than they are for the lessee. I think a good way to understand how it works is shown in the following illustration, which addresses every possible scenario. Group 1 and 2 Criteria How Many of the Four Group I Criteria Are Met? One or more One or more One or more None How Many of the Two Group II Criteria Are Met? Two Two None or one None, one or two Is Asset Being GAAP Accounting Leased MarkedThat Results? Up? No Yes No or Yes No or Yes Direct Financing Lease Sales-type Lease Operating Lease Operating Lease

The following example explains the income statement differences to a lessee between a capital lease and an operating lease. Because the interest expense is higher in the earlier years than it is in later years, the total expenses under capital lease are higher than under operating lease in the earlier years; this pattern then reverses in later years. Note that over the entire term of the lease, the total expenses reported on the income statement are the same.

WE-CAN-DO-IT CONSTRUCTION CO. SCHEDULE OF CHARGES TO OPERATIONS OPERATING LEASE VS. CAPITAL LEASE Capital Lease Executory Total Operating Year Interest Costs Depreciation Charges Lease 2011 2012 2013 2014 2015 7,602.84 5,963.86 4,162.08 2,180.32 19,908.10 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00 10,000.00 20,000.00 29,601.84 20,000.00 27,963.86 20,000.00 26,162.08 20,000.00 24,180.32 20,000.00 22,000.00 100,000.00 129,908.10 25,981.62 25,981.62 25,981.62 25,981.62 25,981.62 129,908.10

Difference (3,620.22) (1,982.24) (180.46) 1,801.30 3,981.62 (0.00)

One item that sometimes perplexes learners is the proper handling by the lessee of executory costs such as property tax and insurance on the asset being leased. The key takeaway here is that you must first determine whether the executory costs are being passed through to the lessee and are included in the rent being charged. If so, then the lessee would back them out of the lease payment to determine true rent in deriving its lease amortization schedule. On the other hand, if the lessee pays the executory costs directly to the outside party, then you would not reverse the executory costs from the lease payments because these lease payments are already true rent. For example, rent is $2,500 per month with $500 for taxes and insurance. The true rent would be $2,000 per month. In the above schedule, the executor costs (insurance, taxes, etc.) were in addition to the lease payment. Lessor Accounting for Direct Financing Versus Sales-Type Lease Let's now compare the lessor's accounting for direct financing leases versus sales-type leases. The only difference in the accounting template between direct financing leases and sales-type leases is in the initial entry. In direct financing leases, the lessor has equipment that gets removed from the books and a net investment established (a lease receivable). In sales-type leases, the lessor has inventory that gets sold. Therefore, in sales-type leases, the inventory is written off, sales revenue is recorded, and the resultant gross profit is recognized. And just as was the case in the direct financing lease, a net investment (or lease receivable) is established for the sales-type lease. Below are the skeleton lessor entries at the inception of the lease for direct

financing leases versus sales-type leases. Direct Financing Lease Dr. Lease Receivable Cr. Equipment Sales-Type Lease Dr. Lease Receivable Dr. Cost of Goods Sold Expense Cr. Sales Revenue Cr. Inventory

Interest revenue on the lease receivable will be higher in the earlier years of the lease than it will be in later years because the lease receivable declines as lease payments are received (and interest is computed on a decreasing balance). A lessor using leasing to market its products usually likes to use sales-type lease accounting rather than operating lease accounting. The total income recorded will be the same for all years combined under both methods; however, there will be much higher earnings in the first year under sales-type lease accounting, because the gross profit from sales is front ended at the inception of the lease. IFRS NOTE: Accounting for leases is defined in IAS 17, which is similar to U.S. GAAP except that "bright-line" criteria are not used. IFRS examines the risks and rewards of ownership. Under U.S. GAAP, the amount initially recorded on a capital lease is the present value of the minimum lease payments. IAS 17 requires the lesser of the fair market value or present value of the minimum lease payments.