Notes(5)

a) distinguish between an operating lease and a finance lease based on the criteria for classifying a lease as a finance lease.

b) prepare the necessary journal entries to record an operating lease in both the lessor's and the lessee's books.

c) prepare the necessary journal entries to record a finance lease in the lessee's books.

d) write and interpret the disclosure requirements for a finance lease and an operating lease in both the lessor's and lessee's books.

A lease is a contract between two parties – a lessor and a lessee. A lease contract gives the lessee rights to use the lessor’s property for a specified period of time in return for periodic cash payments (rent) to the lessor.

There are two basic types of Leases, An Operating Lease and a Finance Lease (a.k.a. Capital Lease)

An Operating Lease is one where the risks and rewards of owning the asset remain with the lessor. Accordingly the asset is not treated as sold by the lessor to the lessee, and remains on the lessor’s books.

A Finance Lease is where the risks and rewards of ownership are deemed to have been passed from the lessor to the lessee. Accordingly the asset is treated as being owned by the lessee.

To determine whether the risks and rewards of ownership have been transferred to the lessee, at least one of the following four (4) criteria must be met.

4. The Present Value (PV) of the minimum lease payments (MLP) is 90% or more of the Fair Market Value (FMV)

Pt.2 - BARGAIN PURCHASE OPTION (BPO) - This option allows the lessee to purchase the leased asset for an amount substantially lower than the expected FMV (see below) at the end of the Lease (e.g. $1).

Pt.3 - MINIMUM LEASE PAYMENTS (MLP) – The payment that the lessee is or can be required to make in connection with the leased asset, including:

3. Guaranteed Residual Value (GRV) – (Some lease contracts require lessees to guarantee the residual value to the lessor)

Pt. 4 - FAIR MARKET VALUE (FMV) – The amount for which an asset could be exchanged between a knowledgeable and willing buyer and a knowledgeable and willing seller in an arm’s length transaction.

The PV of MLP is determined by discounting the MLP by using what is called the “ lessee’s incremental borrowing rate” (in terms of the lessee’s books) or the “lessor’s implicit rate” (in terms of the lessor’s books). If both the lessee’s incremental rate and the lessor’s implicit rate are the Same and also if the residual value is guaranteed by the lessee, then the PV of the MLP = FMV of the Asset. (This allows criteria #4 to be automatically satisfied)

ACCOUNTING ENTRIES FOR OPERATING LEASE

As previously mentioned, with the operating lease, the asset remains on the books of the lessor. The lessor therefore depreciates the asset in the normal fashion. The lessor will then receive periodic payments from the lessee representing rental income to the lessor and rental expense to the lessee.

E.g. A 10-year operating lease is initiated on January 1^st, 1997. Payments are $100,000.00 per year, payable on December 31^st each year.

(2) Each cash payment will consist of an interest portion and a principal portion (which is used to reduce the lease obligation). The lessee will use the Reducing Balance Method, otherwise called the Effective Interest Method, to allocate each cash payment between interest and principal

(3) The lessee may also have to pay other related asset expenses e.g. Insurance and/or Property Taxes.

(5) When the Lease terminates, the balance in the lease obligation account should equal the bargain purchase option or the expected residual value. To clear the lease related accounts from the lessee’s books (when there is no BPO)

If there were a BPO, then the entry to clear the amounts, and therefore effectively exercise the option would be:

1. A 4-year lease is initiated on 1/1/99 for equipment with an expected useful life of 7 years. The equipment reverts back to the lessor upon expiration.

2. Four payments are due to the lessor in the amount of $50,000 per year beginning 31/12/99. An additional sum of $1,000.00 is to be paid annually by the lessee for insurance.

3. The lessee guarantees a $20,000.00 residual value on 31/12/2002 to the lessor. The asset should be depreciated down to this expected residual value.

4. The lessee’s incremental borrowing rate is 20% (same as the lessor’s implicit rate).

Required: Show all the journal entries that are needed to record this lease in the lessee’s books over the life of the Lease.

Example 2 (Finance Lease in lessee’s Books)

1. A 3-year lease is initiated on 1/1/98 for equipment with an expected useful life of 5 years.

2. Three (3) annual payments of $70,000 each are due to the lessor beginning 31/12/98.

3. The lessee can exercise a bargain purchase option on 31/12/2000 for $10,000. The expected residual value at 31/12/2000 is $1,000.00

4. The lessee’s incremental borrowing rate is 10%. (lessor’s implicit rate is unknown)

Required : Show all the journal entries that are needed to record this lease in the lessee’s books over the life of the Lease.

This is the term for a transaction where the owner of property sells the property and then immediately leases it or part of it back from the new owner. This is done so that the original owner can still have use of the asset while generating a major cash inflow.

Note however, that there is not a physical transfer of property. It is also important to note that there are two separate and distinct economic transactions. First, there is a sale of property and second, there is a lease agreement for the same property in which the seller is now the lessee and the buyer is now the lessor.

One of the main reasons for introducing a standard on leases was that a number of Jamaican companies were treating finance leases as operating leases and consequently expensing the entire lease payments (i.e. both interest and principal) thereby reducing profit.

An extract of the disclosure requirements of IAS 17 Leases (as they relate to lessees) is presented below[2]:

1. The amount of assets which are the subject of finance leases. Liabilities related to these assets (shown separately from other liabilities) with the current portions differentiated from the long-term portions.

2. Commitments for minimum lease payments under finance leases and under non-cancellable operating leases with a term of more than one year shown in summary form giving the amount and periods in which the payments will become due.

[1] The entries in the lessor's books are considered to be outside the scope of this course

[2] Paragraphs 57 and 58.