Chapter 14: Accounting for Leases

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Learning Objectives

Introduction to Accounting for Leases

A lease is when a company signs a contract for the exclusive right to use land, property, equipment or other assets for a period of time in exchange for paying a periodic payment to the owner of those assets. For example, a company might need to use a delivery truck for 6 months to deliver merchandise to customers. The company could simply buy a truck to accomplish the business function. However, purchasing a delivery truck might be expensive and the company would end up having a delivery truck that might not be of use after 6 months. An easier way to satisfy the delivery function would be to simply lease a delivery truck for 6 months and pay a periodic payment for the use of that truck. After 6 months, the company simply returns the delivery truck to the owner of the truck.

For many businesses, it has become a standard business practice to lease all real estate used by the business. Retail stores and fast food stores often lease all of their store locations from companies that own real estate. For other companies, they specifically purchase real estate and other assets with the sole intention of leasing these assets to other businesses or individuals.

In terms of lease accounting, the company that is borrowing the asset is called the lessee. The company that is lending the asset is called the lessor. It is very important to remember which accounting you are performing as each business must record different financial transactions.

For many companies, they must evaluate if they should buy or lease assets for their companies. So why would a company want to lease rather than buy their assets? The primary benefits of leasing are the following:

  • Conservation of Cash: When a lessee decides to lease assets, they are generally only required to make the specific lease payments. This would mean that the company would not be required to have a large cash outflow if they decided to purchase the asset. The need to conserve cash would be important for new businesses. Likewise, with a lease, the payments are fixed as specified in the contract. If the company decided to purchase and finance the asset, they might be subject to variable interest rates.
  • Protection Against Loss in Value: Certain asset are subject to rapid obsolescence, such as technology. For companies to stay competitive they will need to always be using the modern equipment. Assets that are subject to obsolescence also will lose their value rapidly when better equipment is released. Leasing the asset will help protect the company from this obsolescence because the asset will be returned at the end of the lease.
  • Flexible Terms: Leases can be written with terms that provide the most flexibility for the lessee. Traditional financing from a bank is generally very specific and does not provide much options for the borrower. Leases can be specified by the time of use or the lease payment can be be based on amount of use of the asset (ie. mileage for a vehicle).
  • Tax Benefits: Certain companies are able to obtain tax benefits by leasing assets. For leasing companies, they might be able to take advantage of depreciation on the assets that the lessee would normally not benefit from. The end result is a more efficient use of tax benefits that might ultimately result in lower taxes for both companies. A traditional purchase or financing deal might not provide these benefits.
  • Off-Balance Sheet Financing: Depending on the circumstances, a company might be able to avoid having to obtain financing to obtain assets. For example, for large equipment, real estate or other costly assets these asset acquisitions would normally require obtaining loans. All of these loans will be reported on the balance sheet as liabilities which are generally viewed as a negative by external users. If a company decides to lease assets instead of buying them then these financing liabilities will not be obtained. These types of transactions are referred to as off-balance sheet financing. There are specific accounting rules to make sure that off-balance sheet financing transactions are not deceptive to external users.

Fundamental Theory of Leases

As previously mentioned, a lease is when a property owner agrees to lend out their asset for a specific period of time to a lessee in exchange for a periodic payment. The opposite type of transaction is when a company simply purchases the asset for use in their business. The company could also purchase the asset directly from the manufacturer and agree to a financing agreement where periodic payments are made. For the purchase option and financing option the purchaser will report an asset on their balance sheet. Any liabilities associated with the transaction will also be recorded. Thus there is an impact on the balance sheet's assets and liabilities.

There are two types of leases: operating and capital.

An operating lease is when a periodic rental expense is recorded at fixed intervals for the lessee. The lessor will record the asset on their books and record depreciation and any other associated expenses related to the asset.

A capital lease is when the lessee will treat the asset as if they own it. The lessee will record depreciation and interest expense associated with the leased asset. The idea of a capital lease is quite strange in reality because the lessee is recording depreciation on asset which they legally do not own. There are four criteria which are used to determine if a lease is a capital lease.

We will learn about both types of leases and how to account for them as the lessee and lessor.

Operating Leases

An operating lease is a lease which does not meet the classification criteria (discussed later) to be recorded as a capital lease. Operating leases are easy to understand because they follow the economic substance of the transaction. For example, if a company, the lessee, leases a vehicle from the lessor, or the owner of the vehicle then the following would be the impacts of this transaction:

For the lessee:

  • lessee receives the right to use the vehicle
  • lessee sends a cash payment to the lessor for the right to use the vehicle
  • lessee does not record deprecation associated with the vehicle
  • upon expiration or termination of the lease agreement, the vehicle is returned to the lessor.

For the lessor:

  • lessor gives the vehicle to the lessee for temporary use
  • lessor receives a cash payment for selling the right to use the vehicle to the lessee
  • lessor records depreciation related to the vehicle
  • upon expiration or termination of the lease agreement, the vehicle is returned to the lessor.

Operating Leases - Accounting by the Lessee

Recording operating leases are very straight forward. For the lessee, the only entry that is recorded is the cash payments to the lessor and the associated lease/rent expense. To not violate the matching principle, the rent expense must be matched to the period of benefit. For most assets, the straight line method is most of used. Accruals and deferrals are used if the cash payments for the asset are not consistent. For example, if a lump-sum payment is made at the beginning or end of the lease term or if the lease agreement involves varying amounts of cash paid (e.g. first month free).

Example: Howard company enters into a lease for a vehicle for a lease term of 6 months. At the end of the each month of the lease term, Howard company will pay $1,000 to the lessor. The following journal entry is used to record this transaction at the end of each month:

jan 31st debit lease expense 1,000

credit cash 1,000

Example: Howard company enters into a lease for a vehicle for a lease term of 6 months. The lease agreement provides for the first month free and the remaining 5 months at a rate of $1,200 per month.

The first month would be recorded by using the following journal entry:

jan 31st debit lease expense 1,000

credit lease payable 1,000

The remaining months would be recorded with the following journal entry:

Feb 28th debit lease expense 1,000

debit lease payable 200

credit cash 1,200

Example: Howard company enters into a lease for a vehicle for a lease term of 6 months. The lease agreement requires the lessee to pay the entire 6 months at the end of the first month for a total cost of $6,000. The following entry would be used to record this transaction.

The following entry would be recorded at the end of the first month:

Jan 31st debit lease expense 1,000

debit prepaid rent 5,000

credit cash 6,000

The remaining 5 months would be recorded using the following journal entry:

feb 28th debit lease expense 1,000

credit prepaid rent 1,000

Operating Leases - Accounting by the Lessor

For the lessor, the two major accounting entries are related to depreciating the asset and recognizing revenue related to the cash payments for use of the asset. Chapter 6: long-term assets, discusses how to depreciate assets. When an asset is leased to a customer, depreciation should continue by using a depreciation method which matches the decay in the asset over time. The lessor continues to report the asset on their balance sheet even though they have leased the right to use the asset to a customer.

Revenue related to the leased asset should be recognized using revenue recognition rules.

Example: Clark Company, enters into a lease agreement for a vehicle for 6 months. Each month the company will receive $1,000 related to the lease at the beginning of the month.

At the inception of the lease, the following entry would be recorded (one entry):

Jan 1st, debit cash 1,000

debit account receivable 5,000

credit unearned lease revenue 6,000

At the end of each month, the following journal entry would be recorded (total of 6 entries over the life of the lease):

Jan 31st Debit unearned lease revenue 1,000

Credit lease revenue 1,000

At the beginning of each month, the following journal entry would be recorded (total of 5 entries over the life of the lease):

Feb 1st, debit cash 1,000

credit account receivable 1,000

If any incidental expenses are incurred related to the lease (e.g maintenance) then these expenses are recorded in the period incurred.

Capital Leases

Capital Leases for the Lessee

Capital Leases for the Lessor

Incidental Topics in Lease Accounting