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A lease is a contract between a lessor (the owner of the property) and a lessee (the user of the
property). Normally the lessee makes periodic payments in exchange for the use of the property.
The lease term can be for any period of time that is acceptable to both parties. The periodic
payments are called rental payments. The obligation for taxes, insurance and maintenance is
specified in the lease contract.
Example: Spencer Company leases a piece of equipment for five years. The lease meets the
criteria for capitalization. The minimum lease payments are $2,107 per month for five years.
The implicit interest rate is 10% per annum. The following is an amortization schedule for the
first calendar year.
Interest Carrying
Date Cash Paid Expense Principal Value
4/1/03 100,000
4/1/03 2,107 0 2,107 97,893
5/1/03 2,107 816 1,291 96,602
6/1/03 2,107 805 1,302 95,300
7/1/03 2,107 794 1,313 93,987
8/1/03 2,107 783 1,324 92,663
9/1/03 2,107 772 1,335 91,328
10/1/03 2,107 761 1,346 89,982
11/1/03 2,107 750 1,357 88,625
12/1/03 2,107 739 1,368 87,257
Note that the first payment and the origination of the lease are on the same day. Normally a
lease requires that the lessee make one or more lease payments on the signing of the lease and
transfer of the property. Because this is a capitalized lease instead of an installment purchase the
journal entry to record the transaction would be as follows:
The payment made at the signing of the lease would be recorded as follows:
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The payment made on May 1, 2003 would be recorded in the same manner as a payment on an
installment note.
Capital Leases
Leases are accounted for in one of two ways. If the lease contract is noncancelable and transfers
substantially all of the benefits and risks of ownership to the lessee the lease is capitalized. If the
lease does not meet these criteria it is accounted for as an operating lease.
In a capitalized lease the lessee records the leased property as an asset and the lease obligation as
a liability. The amounts are measured based on the present value of the future rental payments.
The lessor records the lease as a sale recording the present value of the future rental payments as
the selling price and recognizing the costs of the property in the income statement.
There are very specific criteria that must be met for a lease to qualify as a capital lease. The
lease must be noncancelable and meet one or more of the following criteria:
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In calculating 90% of the fair value the lessee uses the lesser of:
1. The lessees incremental borrowing rate, or
2. If known the implicit interest rated computed by the lessor
EXERCISE:
Spencer Company leased equipment from Capital Leasing Company. The lease term is 5 years
and requires equal rental payments of $30,000 at the beginning of each year. The equipment has
a fair value at the inception of the lease of $138,000, and estimated useful life of 8 years, and no
residual value. Spencer Company pays all executory costs directly to third parties. Capital
Leasing Company set the annual rental to earn a rate of return of 10%, and this fact is known to
Spencer Company. The lease does not transfer title or contain a bargain purchase option.
Review the criteria for capitalization and determine if Spencer Company should capitalize this
lease. Respond to each of the criteria listed below:
Response:
3. Is the term of the lease equal to 75% or more of the economic life of the leased property?
Response:
Solution: No, the term of the lease is not equal to or greater than 75% of the economic life of the
property.
5 Years
= 62.5% < 75%
8 Years
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4. Does the present value of the minimum lease payments (excluding executory costs) equal or
exceed 90% of the fair value of the leased property?
Response:
Solution: Yes, the present value of the minimum lease payments exceeds 90% of the fair value
of the property.
Analysis of factor:
PVOA, n=5, i=10% 3.79079
1 plus 10% 1.10000
PVAD, n=5, i=10% 4.16987
90% of the FV
FV 90% Amount
138,000 * 90% = 124,200
PV 90% FV
125,096 > 124,200
Depreciation
Depreciation is recorded on the leased property based on the depreciation policies of the lessee
company. If the lease transfers ownership or contains a bargain purchase option the depreciation
is allocated over the useful economic life of the leased asset. If the lease does not contain one of
these two provisions depreciation is allocated over the term of the lease.
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The effective interest method is used to allocate between the interest and principal.
OPERATING LEASES
Example: Using the information provided above, if the lease does not qualify as a capitalized
lease then Spencer Leasing Company will treat the lease as an operating lease. Under these
circumstances the journal entries to record the receipt of rental payments and the annual
depreciation on the leased equipment would be recorded as follows.
CAPITALIZED LEASES
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give the lessor a 12% return, which is known to the lessee. The first step is to calculate the
present value of the future minimum lease payments.
The executory costs are removed to give us the net lease payment. Using Excel we can calculate
the present value of the 10 lease payments. Remember this is an annuity due so the first payment
does not include any interest. Using a 12% discount rate, which is the lesser of the lessees
incremental borrowing rate or the implicit interest rate computed by the lessor is know by the
lessee, the present value of the minimum lease payments is $151,878. This is the amount that we
will capitalize as an asset and liability at the inception of the lease.
If we assume that the executory costs are for property taxes then the first journal entry to record
the signing of the lease and the payment made on January 1, 2000 is as follows.
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Economics of Leasing
In order to lease as opposed to selling products manufacturers must earn a return on the lease
above and beyond the profit on the sale of the product. The rate of return that the lessor must
earn is called the implicit rate.
Depending on the circumstances, from the lessors perspective a capital lease may be accounted
for in one of two ways.
1. Direct financing lease
2. Sales-type lease
If at the inception of the lease the lease meets one or more of Group I criteria and both of the
Group II criteria the lease will be classified as either a direct financing lease or a sales-type lease.
The capitalization criteria for a lessor are as follows:
Group I
1. The lease transfers ownership of the property to the lessee
2. The lease contains a bargain purchase option
3. The lease term is equal to 75% or more of the estimated economic life of the leased
property
4. The present value of the minimum lease payments (excluding executory costs) equals or
exceeds 90% of the fair value of the leased property
Group II
3. Collectibility of the payments required from the lessee is reasonably predictable
4. No important uncertainties surround the amount of unreimbursed costs yet to be incurred
by the lessor under the lease
There are three pieces of information necessary to record a direct financing lease.
1. Lease Payments Receivable (Gross Investment)
The minimum lease payments plus the unguaranteed residual value accruing to the lessor at
the end of the lease term is recorded as an asset in the general ledger.
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The fair market value of the property (normally the cost of the item to the lessor) less the
lease payments receivable.
Example: Spencer Leasing Company enters into a contract to lease equipment to Alexander
Company. The equipment is purchased from Sophie Company for $151,878. Assume that the
lease meets the criteria for capitalization. As the lessor Spencer Leasing Company is providing
the financing for Alexander Company and therefore this will be accounted for as a direct
financing lease. The same facts and circumstances will be used to demonstrate the recording of
the lease transactions. The first transaction that must be recorded is the purchase of the
equipment by Spencer Leasing Company. The company will purchase and lease (sell) the
equipment in simultaneous transactions.
FV of equipment $151,878
To analyze the information that we will need to book this lease transaction and the periodic
payment the following amortization schedule is provided.
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ANNUAL
LEASE EXECUTORY NET LEASE
DATE PAYMENT COSTS LEASE INTEREST PRINCIPLE OBLIGATION
1/1/00 151,878
1/1/00 25,000 1,000 24,000 0 24,000 127,878
1/1/01 25,000 1,000 24,000 15,345 8,655 119,223
1/1/02 25,000 1,000 24,000 14,307 9,693 109,530
1/1/03 25,000 1,000 24,000 13,144 10,856 98,674
1/1/04 25,000 1,000 24,000 11,841 12,159 86,515
1/1/05 25,000 1,000 24,000 10,382 13,618 72,896
1/1/06 25,000 1,000 24,000 8,748 15,252 57,644
1/1/07 25,000 1,000 24,000 6,917 17,083 40,561
1/1/08 25,000 1,000 24,000 4,867 19,133 21,429
1/1/09 25,000 1,000 24,000 2,571 21,429 0
250,000 10,000 240,000 88,122 151,878
The lease payments receivable include all payments less executory costs for the duration of the
lease. In this example, the lease payments receivable will be $240,000. The unearned interest
revenue is the difference between the lease payments receivable and the fair market value of the
property at the inception of the lease. In this example, the unearned interest is $88,122
($240,000 - $151,878).
At the signing of the lease, on January 1, 2000, we will need to book the lease payments
receivable, remove the equipment from the lessors books and record the unearned interest
revenue. The following journal reflects this transaction for this example.
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Example: Spencer Manufacturing Company sells and leases equipment to pet supply
distributors. Assume the same facts and circumstances as in the above two examples except that
it cost Spencer Manufacturing Company $110,000 to manufacture the equipment that is going to
be leased to Alexander Company. We will assume that Alexander Company has guaranteed a
residual value at the end of the lease is $5,000.
Under this scenario the selling price of the equipment has changed. The following provides a
calculation of the selling price of the equipment.
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With the guaranteed residual the net present value of the entire package is now $153,488. We
can now calculate the rest of the components of the sale-type lease agreement. The following
provides this analysis.
The gross investment includes the ten annual payments and the guaranteed residual.
The unearned interest revenue is equal to the gross investment less the present value of the
minimum lease payments and the present value of the guaranteed residual.
The sales price is the present value of the minimum lease payments plus the present value of the
guaranteed residual.
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The gross profit is the sales price less the cost of goods sold.
Gross Profit
Sales price 153,488
Cost of goods sold 110,000
Gross profit 43,488
To better visualize the transactions in this sales-type of lease the following is an amortization
schedule prepared for Spencer Leasing Company.
ANNUAL
LEASE EXECUTORY NET LEASE
DATE PAYMENT COSTS LEASE INTEREST PRINCIPAL OBLIGATION
1/1/00 153,488
1/1/00 25,000 1,000 24,000 0 24,000 129,488
1/1/01 25,000 1,000 24,000 15,539 8,461 121,027
1/1/02 25,000 1,000 24,000 14,523 9,477 111,550
1/1/03 25,000 1,000 24,000 13,386 10,614 100,936
1/1/04 25,000 1,000 24,000 12,112 11,888 89,048
1/1/05 25,000 1,000 24,000 10,686 13,314 75,734
1/1/06 25,000 1,000 24,000 9,088 14,912 60,822
1/1/07 25,000 1,000 24,000 7,299 16,701 44,120
1/1/08 25,000 1,000 24,000 5,294 18,706 25,415
1/1/09 25,000 1,000 24,000 3,050 20,950 4,465
12/31/09 5,000 5,000 535 4,465 0
255,000 10,000 245,000 91,512 153,488
With the above computations complete we can now prepare the journal entries to record the lease
transactions. The first journal entry is to record the sales-type lease at inception.
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