1. 1
Leases
Sid Glandon, DBA, CPA
Associate Professor of Accounting
University of Texas at El Paso

2. 2
Basics of Leasing
 Lease
– Contractual agreement between lessor and
lessee
– Gives lessee right to use specific property
– Specifies duration and rental payments
– Executory costs
• Taxes, insurance and maintenance
• May be assumed by either party

3. 3
Advantages
 100% financing at fixed rates
 Protection against obsolescence
 Flexibility
 Less costly financing
 AMT problems avoided
 Off-balance-sheet financing

4. 4
Classification of Leases
 Capital leases
– If lease transfers substantially all of the
benefits and risks of ownership
– Must be noncancelable
 Operating leases
– Do not substantially transfer benefits and
risks of ownership

5. 5
Accounting by Lessee
 Capitalize if noncancelable, and
– Transfers ownership to lessee, or
– Contains bargain purchase option, or
– Lease term equal to 75% or more of
estimated economic life of property, or
– PV of minimum lease payments equals or
exceeds 90% of fair value of property

6. 6
Accounting by Lessee
Does lease agreement transfer ownership? Yes
No
Is there a bargain purchase option?
Is the lease term ≥ 75% of economic
Is PV of payments ≥ 90%
No
No
No
Yes
Yes
Yes
Capital Lease
Operating Lease

7. 7
Bargain Purchase Option
 Allows lessee to buy leased asset
 Price significantly lower that expected
fair value at date of option
 Determined at inception of lease
 Must render option reasonably assured

8. 8
Economic Life Test
 Lease period equals or exceeds 75% of
asset’s economic life
 Lease term is considered the fixed
noncancelable term of lease
 Bargain renewal options are included
 If lease starts during last 25% of life of
asset, test cannot be used

9. 9
Recovery of Investment
 PV of minimum lease payments equals
or exceeds 90% of fair value
 Minimum lease payments
– Payments
– Guaranteed residual value
– Penalty for failure to renew or extend
– Bargain purchase option

10. 10
Discount Rate
 The lesser of
– Lessee’s incremental borrowing rate, or
– The implicit interest rate

11. 11
Executory Cost
 Insurance, maintenance and taxes
 Should be excluded from minimum
lease payments

12. 12
Residual Values
 Estimated fair value at end of lease
 Guaranteed residual value
– An additional lease payment
 Unguaranteed residual value
– Same as no residual value to lessee
 Lessor assumes residual value will be
realized whether guaranteed or not

13. 13
Capitalized Leases
Accounting by Lessee
 Asset and Liability
– Recorded at the lesser of the PV of
minimum lease payments or FMV
 Depreciation Period
– Economic life
• Lease transfers ownership
• Lease has bargain purchase option
– Term of lease

14. 14
Fact Pattern
 Date: January 1, 2006
 Lease term: 10 years
 Discount rate: 8%
 Annual lease payments: $12,000
 Executory costs: $1,000
 Title transfers at end of lease term
 Economic life of asset: 12 years
 Residual value: $0

15. 15
Date
Annual
Lease
Payment
Executory
Costs Net Lease Interest Principal
Lease
Oblication
1/1/06 $79,716
1/1/06 $12,000 $1,000 $11,000 $11,000 68,716
1/1/07 12,000 1,000 11,000 $5,497 5,503 63,213
1/1/08 12,000 1,000 11,000 5,057 5,943 57,270
1/1/09 12,000 1,000 11,000 4,582 6,418 50,852
1/1/10 12,000 1,000 11,000 4,068 6,932 43,920
1/1/11 12,000 1,000 11,000 3,514 7,486 36,433
1/1/12 12,000 1,000 11,000 2,915 8,085 28,348
1/1/13 12,000 1,000 11,000 2,268 8,732 19,616
1/1/14 12,000 1,000 11,000 1,569 9,431 10,185
1/1/15 12,000 1,000 11,000 815 10,185 0
$120,000 $10,000 $110,000 $30,284 $79,716
Lease Amortization Schedule

16. 16
Date Account Debit Credit
1/1/06 Equipment under capital lease $79,716
Obligations under capital lease $79,716
Date Account Debit Credit
1/1/06 Obligations under capital lease $11,000
Executory costs, insurance and taxes 1,000
Cash $12,000
To record the signing of a lease classified as a capital lease.
To record the initial lease payment at the signing of a lease classified as a
capital lease.

17. 17
Date Account Debit Credit
12/31/06 Depreciation expense $6,643
Accumulated depreciation $6,643
Analysis of depreciation expense:
Capitalized cost of equipment $79,716
Salvage (residual) value 0
Depreciable base 79,716
Economic (service) life 12
Annual depreciation $6,643
To record depreciation expense on equipment under capital lease.

18. 18
Date Account Debit Credit
1/1/07 Obligations under capital lease $5,503
Executory costs, insurance and taxes 1,000
Interest expense 5,497
Cash $12,000
To record the payment of principal, executory costs and interest on capital
lease.

19. 19
Operating Leases
Accounting by Lessee
 Lessee assigns rent to periods
benefiting
 Ignores any commitments for future
payments
 Note disclosure
– For all operating leases that have
noncancelable lease terms in excess of
one year

20. 20
Classification of Leases
Accounting by Lessor
 Direct financing leases
 Sales type leases
 Operating leases

21. 21
Direct Financing Lease
 Must meet group I capitalization criteria
and
– Collectibility of payments must be
reasonably assured
– Lessor’s performance must be
substantially complete
 FV of asset equal to lessor’s book value

22. 22
Sales Type Lease
 Must meet group I capitalization criteria and
– Collectibility of payments must be reasonably
assured
– Lessor’s performance must be substantially
complete
 FV of asset should not be equal to lessor’s
book value
– Lease contains a dealer’s gross profit

23. 23
Operating Lease
Accounting by Lessor
 Does not meet criteria for capitalized
lease
 Rental receipts recorded as rental
receipts
 Leased asset depreciated
 Leased equipment and accumulated
depreciation separately classified

24. 24
Accounting by Lessor
Does lease four criteria in Group I? No
Yes
Is collectability of payments assured?
Is performance substantially complete?
Yes
Yes
No
No
No
Operating Lease
Direct FinancingDoes asset FMV = lessor's book Yes
Sales Type

25. 25
Direct Financing Lease
 Debit, Lease receivable
– Gross sum of lease payments
 Credit, Unearned interest revenue
– Lease receivable less FMV of asset
 Credit, Inventory of equipment
– Lessor’s cost of the asset

26. 26
Fact Pattern
 Date: January 1, 2005
 Inventory of equipment: $103,500
 Lease term: 6 years
 Implicit interest rate: 8%
 Payments: $20,000
 Residual value: $5,786

27. 27
Date Payment Interest
Amortization
of Principal Balance
1/1/05 $103,500
1/1/05 $20,000 $20,000 83,500
1/1/06 20,000 $6,680 13,320 70,180
1/1/07 20,000 5,614 14,386 55,794
1/1/08 20,000 4,464 15,536 40,258
1/1/09 20,000 3,221 16,779 23,479
1/1/10 20,000 1,878 18,122 5,357
12/31/10 5,786 429 5,357 0
$125,786 $22,286 $103,500
Lease Amortization Schedule

28. 28
Date Account Debit Credit
1/1/05 Lease receivable $125,786
Unearned interest revenue $22,286
Inventory 103,500
To record the signing of a direct financing lease.

29. 29
Sales Type Leases
 Debit, Lease Receivable
– Lease payments plus residual
 Debit, Cost of Goods Sold
– Lessor’s cost
 Credit, Sales Price of Asset
– PV of minimum lease payments
 Credit, Unearned Interest Revenue
– Lease Receivable less FMV of asset
 Credit, Inventory
– Lessor’s cost

30. 30
Fact Pattern
 Date: January 1, 2005
 Inventory of equipment: $60,000
 FMV of equipment: $103,500
 Lease term: 6 years
 Implicit interest rate: 8%
 Payments: $20,000
 Residual value: $5,786

31. 31
Date Payment Interest
Amortization
of Principal Balance
1/1/05 $103,500
1/1/05 $20,000 $20,000 83,500
1/1/06 20,000 $6,680 13,320 70,180
1/1/07 20,000 5,614 14,386 55,794
1/1/08 20,000 4,464 15,536 40,258
1/1/09 20,000 3,221 16,779 23,479
1/1/10 20,000 1,878 18,122 5,357
12/31/10 5,786 429 5,357 0
$125,786 $22,286 $103,500
Lease Amortization Schedule

32. 32
Date Account Debit Credit
1/1/05 Lease receivable $125,786
Cost of goods sold $60,000
Sales revenue $103,500
Unearned interest revenue $22,286
Inventory 60,000
To record the signing of a sales type lease.