Prepared by

Coby Harmon
University of California, Santa
Barbara
21-1
Westmont College
 CHAPTER 21
Accounting for Leases

LEARNING
OBJECTIVES
After studying this chapter, you should be able to:
1. Describe the environment 3. Explain the accounting for
related to leasing leases by lessors.
transactions.
4. Discuss the accounting
2. Explain the accounting for and reporting for special
leases by lessees. features of lease
arrangements.

21-2
 PREVIEW OF CHAPTER 21

Intermediate Accounting
IFRS 3rd Edition
Kieso ● Weygandt ● Warfield
21-3
 LEARNING OBJECTIVE 1
The Leasing Environment Describe the environment
related to leasing
transactions.

A lease is a contractual agreement between a lessor

and a lessee, that gives the lessee the right to use
specific property, owned by the lessor, for a specified
period of time.
Largest group of leased equipment involves:
u Information technology equipment
u Transportation (trucks, aircraft, rail)
u Construction
u Agriculture

21-4 LO 1
 ILLUSTRATION 21.2
What Do Companies
Lease?

21-5
 The Leasing Environment

Advantages of Leasing—Lessees
1. 100% financing at fixed rates.

2. Protection against obsolescence.

3. Flexibility.

4. Less costly financing.

21-6 LO 1
 The Leasing Environment

A Look at the Lessor

Captive
Banks Independents Leasing
Companies
► Credit Suisse ► CNH Capital
(CHE) (NLD) (for
► Chase (USA) CNH Global),

► Barclays (GBR) ► BMW Financial

Services (DEU)
► Deutsche Bank (for BMW)
(DEU)
14% ► IBM Global
Financing
(USA) (for
IBM)
55% Market Share 31%

21-7 LO 1
 The Leasing Environment

Advantages of Leasing—Lessor
1. Often provides profitable interest margins.

2. It can stimulate sales of a lessor’s product.

3. It often provides tax benefits to various parties in

the lease.

4. It can provide a high residual value to the lessor.

21-8 LO 1
 LEARNING OBJECTIVE 2
Lease Accounting Explain the accounting for
leases by lessees.

Conveys the right to control the use of identified

property, plant or equipment (an identified asset)
for a period of time in exchange for consideration.”

The various views on capitalization of leases are as

follows.
1. Do not capitalize any leased assets.

2. Capitalize leases that are similar to installment

purchases.

3. Capitalize all long-term leases.

4. Capitalize firm leases where the penalty for non-

21-9 LO 2
performance is substantial.
 Lease Accounting

IASB requires lessees to capitalize all leases.

Only exceptions:
u leases covering a term of less than one year or

u lease of property with a value less than $5,000.

Right to use property under the lease is an

u asset, and

u lessee’s obligation to make payments is a

liability.

21- LO 2
10
 Lease Accounting

The lessee
u recognizes interest expense on the lease liability
using the effective-interest method and

u records depreciation expense on the right-of-use

asset.

This accounting (finance lease) is applied whether

the lease is effectively
u a purchase of the asset or

u when the lessee only controls the use of the asset.

21- LO 2
11
 Measurement of the Lease Liability
and Lease Asset

Lease Term
u The fixed, non-cancelable term of the lease.

u Bargain-renewal option can extend this period.

l At the commencement of the lease, the difference
between the renewal rental and the expected fair
rental must be great enough to make exercise of
the option to renew reasonably certain.

21- LO 2
12
 Lease Term

Illustration: Carrefour (FRA) leases Lenovo (CHN) PCs

for two years at a rental of $100 per month per
computer and subsequently can lease them for $10
per month per computer for another two years. The
lease clearly offers a bargain-renewal option; the
lease term is considered to be four years.

21- LO 2
13
 Measurement of the Lease Liability
and Lease Asset

Lease Payments
l Fixed payments.

l Variable payments that are based on an index or

a rate.

l Guaranteed residual value.

l Payments related to purchase or termination

options that the lessee is reasonably certain to
exercise.

21- LO 2
14
 Measurement of the Lease Liability
and Lease Asset

Discount Rate
Lessee should compute the present value of the
lease payments using the implicit interest rate.
► This rate, at commencement of the lease, which
causes the aggregate present value of the lease
payments and unguaranteed residual value to be
equal to the fair value of the leased asset.

In the event that it is impracticable to determine

the implicit rate, the lessee uses its incremental
21- borrowing rate. LO 2
15
 Subsequent Lease Accounting

To illustrate the accounting for a lease using the

finance lease method, assume that CNH Capital
(NLD) (a subsidiary of CNH Global) and Ivanhoe
Mines Ltd. (CAN) sign a lease agreement dated
January 1, 2019, that calls for CNH to lease a
backhoe to Ivanhoe beginning January 1, 2019.

The terms and provisions of the lease agreement and

other pertinent data are as follows.

21- LO 2
16
 Terms and provisions of the lease agreement:
• The term of the lease is five years. The lease agreement is
non-cancelable, requiring equal rental payments of
€20,711.11 at the beginning of each year (annuity-due
basis).
• The backhoe has a fair value at the commencement of the
lease of €100,000, an estimated economic life of five
years, and a guaranteed residual value of €5,000. (Ivanhoe
expects that it is probable that the expected value of the
residual value at the end of the lease will be greater than
the guaranteed amount of €5,000.)
• The lease contains no renewal options. The backhoe reverts
to CNH Capital at the termination of the lease.
• Ivanhoe’s incremental borrowing rate is 5 percent per
year.
• Ivanhoe depreciates its equipment on a straight-line basis.
21- LO 2
17 • CNH sets the annual rental rate to earn a rate of return of
 Lessee Accounting: Example 1

Ivanhoe computes the lease liability and the amount

capitalized as a right-of-use asset as follows:

Payment € 20,711.11
Present value factor (i=4%,n=5) x 4.62990
PV of lease payments €95,890.35

Ivanhoe uses CNH's implicit interest rate of 4 percent

instead of its incremental borrowing rate of 5 percent
because it is known to Ivanhoe.

21- * Rounded by €0.02. LO 2

18
 Lessee Accounting: Example 1

Ivanhoe records the finance lease on its books on January

1, 2019, as:

Right-of-Use Asset 95,890.35

Lease Liability
95,890.35
Ivanhoe records the first lease payment on January 1,
2019, as follows.

Lease Liability 20,711.11

Cash
20,711.11

21- LO 2
19
 ILLUSTRATION 21.7
Lease Amortization Schedule—Lessee

21- LO 2
20
 ILLUSTRATION
21.7

Prepare the entry to record accrued interest at Dec. 31,

2019.
Interest Expense 3,007.17
Lease Liability 3,007.14

21- * rounding LO 2
21
 Lessee Accounting: Example 1

Depreciation of the right-of-use asset over the five-year

lease term, applying Ivanhoe’s normal depreciation
policy (straight-line method), results in the following
entry at December 31, 2019.
Depreciation Expense 19,178.07
Right-of-Use Asset (€95,890.35 ÷ 5 years)
19,178.07

21- LO 2
22
 Lessee Accounting: Example 1

The statement of financial position as it relates to lease

transactions at December 31, 2019.
ILLUSTRATION
21.8
Statement of
Financial Position
Presentation

On its December 31, 2019, income statement, Ivanhoe

reports,
ILLUSTRATION
21.9
Income Statement
presentation

21-
23
 ILLUSTRATION
21.7

Ivanhoe records the second lease payment as follows.

Lease Liability (€3,007.17 + €17,703.95) 20,711.11

Cash 20,711.11

21- * rounding LO 2
24
 ILLUSTRATION
21.7

If Ivanhoe purchases the equipment from CNH at the

termination of the lease at a price of €5,000 and the
estimated remaining life of the equipment is two years, it
makes the following entry.
Equipment 5,000
Cash 5,000
21- * rounding LO 2
25
 Lessee Accounting: Example 2

To illustrate a situation where the expected residual

value is below the guaranteed residual value, assume
in the earlier CNH/Ivanhoe example that it is
probable that the residual value will be €3,000
instead of the guaranteed amount of €5,000. If
Ivanhoe estimates the residual value of the backhoe at
the end of the lease to be €3,000, Ivanhoe includes
€2,000 (€5,000 − €3,000) as an additional lease
payment in determining the lease liability and right-
of-use asset.

21- LO 2
26
 Lessee Accounting: Example 2

Ivanhoe computes the lease liability and the amount

capitalized as a right-of-use asset as follows:

Payment € 20,711.11
Present value factor (i=4%,n=5)x 4.62990
PV of lease payments € 95,890.35 *
Probable residual value € 2,000,00
PV factor (i=4,n=5) x .82193
PV of probable residual value 1,643.86
Lessee’s lease liability/right-of-use asset € 97,534.21

21- * Rounded by €0.02. LO 2

27
 Lessee Accounting: Example 2

Ivanhoe makes the following entries to record the lease

and the first payment on January 1, 2019, as:

Right-of-Use Asset 97,534.21

Lease Liability 97,534.21

Lease Liability 20,711.11

Cash 20,711.11

21- LO 2
28
 ILLUSTRATION 21.11
Lease Amortization Schedule—Lessee
21- LO 2
29
ILLUSTRATION 21.12
Journal Entries—Guaranteed Residual Value

21- LO 2
30
 Example 2: Residual Value Loss

Assume that due to poor maintenance of the backhoe,

Ivanhoe and CNH agree that the fair value of the asset is
zero upon returning the backhoe to CNH on January 1,
2024. In this case, Ivanhoe reports a loss of €3,000.
Under the expected payment scenario, Ivanhoe makes
the following entry.
Loss on Lease (€5,000 − €2,000) 3,000
Cash 3,000

Under the no expected payment scenario, Ivanhoe makes

the following entry.
Loss on Lease (€5,000 − €0) 5,000
Cash 5,000
21- LO 2
31
 Example 2: Bargain Purchase Option

Bargain purchase option allows the lessee to purchase

the leased property for a future price that is
substantially lower than the asset’s expected future fair
value.

l Lessee must increase the present value of the lease

payments by the present value of the option price.

l Affects the accounting in the same way as a

guaranteed residual value with a probable amount
to be owed.

21- LO 2
32
 Lessee Accounting: Example 3

Unguaranteed Residual Value: Assume that Hathaway

Disposal (lessor) and Marks and Spencer plc (M&S)
(GBR) (the lessee) sign a lease agreement dated January
1, 2019. The lease agreement specifies that Hathaway
will grant right-of-use of one of its standard cardboard
compactors for use at one of M&S’s stores. Information
relevant to the lease is as follows.

l Lease term is three years, non-cancelable, requires

rental payments of £17,620.08 at the beginning
of each year.

l Compactor has a cost and fair value at

commencement of the lease of £60,000, an
21-
estimated economic life of seven years, and an LO 2
33
 Lessee Accounting: Example 3

Unguaranteed Residual Value: Assume that Hathaway

Disposal (lessor) and Marks and Spencer plc (M&S)
(GBR) (the lessee) sign a lease agreement dated January
1, 2019. The lease agreement specifies that Hathaway
will grant right-of-use of one of its standard cardboard
compactors for use at one of M&S’s stores. Information
relevant to the lease is as follows.

l Lease contains no renewal options, the compactor

reverts to Hathaway at the termination of the
lease.

l Implicit rate of the lessor is not known by M&S.

M&S’s incremental borrowing rate is 6 percent.
21- LO 2
34
 Lessee Accounting: Example 3

The present value of the lease payments for M&S in this

situation is £49,924.56 (£17,620.08 × 2.83339 (PVF
= AD 3,6%)).

The lease liability of £49,924.56 does not include any

payments related to the unguaranteed residual value.

M&S makes the following entries.

January 1, 2019
Right-of-Use Asset 49,924.56
Lease Liability 49,924.56

Lease Liability 17,620.08

Cash 17,620.08
21- LO 2
35
ILLUSTRATION 21.14
Lease Amortization Schedule—Lessee

21- LO 2
36
21- ILLUSTRATION 21.15 Journal Entries by Lessee LO 2
37
 Low-Value and Short-Term Leases

IASB provided an exception to required capitalization

of all leases:
1. Low-Value Leases (underlying assets with values
of $5,000 or less), lessee may elect to expense
lease payments as incurred.
2. Short-Term Leases (lease term of 12 months or
less), lessee may elect to expense lease payments
as incurred.

21- LO 2
38
 LEARNING OBJECTIVE 3
Lessor Accounting Explain the accounting for
leases by lessors.

Economics of Leasing
Lessor determines the amount of the rental
payment, not the lessee.
u Determines payment using rate of return
(implicit rate).
u Considers credit standing of lessee.
u Length of the lease.
u Status of the residual value (guaranteed versus
unguaranteed).

21- LO 3
39
 Lessor Accounting

Economics of Leasing
In Examples 1 and 2, CNH determined the implicit rate
to be 4 percent, the fair value of the equipment to be
€100,000, and the residual value to be $5,000. CNH
then computes the lease payment as shown.

Fair value of leased equipment €100,000.00

Less: Present value of the residual value
(€5,000 × .82193 (PVF 5,4%)) 4,109.65
Amount to be recovered by lessor through
lease payments € 95,890.35
Five beginning-of-year lease payments to earn a
4% return (€95,890.35 ÷ 4.62990) (PVF-AD 5,4%)) €
20,711.11
21- LO 3
40
 Classification of Leases by the Lessor

For accounting purposes, the lessor classifies leases as

a
u Finance lease or an,
u Operating lease.
For a finance lease, it must be non-cancelable and meet
at least one of five tests in Illustration 21.18.

To meet one of these five tests, the lessor must transfer

control of a substantial portion of the underlying asset
to the lessee or provide ownership of the underlying
asset to the lessee.

21- LO 3
41
 For a finance lease,
• must be non-
cancelable and
• meet at least one
of the five tests.

ILLUSTRATION 21.218
Lease Classification Tests
21- LO 3
42
 Classification of Leases by the Lessor

Transfer of Ownership Test

u If the lease transfers ownership of the asset to the
lessee, it is a finance lease.

Purchase Option Test

u The lease purchase option allows the lessee to
purchase the property for a price that is
significantly lower than the underlying asset’s
expected fair value at the date the option
becomes exercisable (bargain purchase option).

21- LO 3
43
 Classification of Leases by the Lessor

Lease Term Test

u When the lease term is a major part of the
remaining economic life of the leased asset,
companies should use the finance method.

u Guideline: If the lease term is 75 percent or greater

of the economic life of the leased asset, the lease
meets the lease term test.

21- LO 3
44
 Classification of Leases by the Lessor

Present Value Test

u If the present value of the lease payments is
reasonably close to the fair value of the asset,
the lessee should use the finance method.

u Guideline: if the present value of the lease

payments equals or exceeds 90 percent of the
fair value of the asset, then a lessee should use
the finance method.

21- LO 3
45
 Classification of Leases by the Lessor

Lease Payments
Generally include:

1. Fixed payments.

2. Variable payments.

3. Residual values (guaranteed or not).

4. Payments the lessee is reasonably certain to

exercise.

21- LO 3
46
 Classification of Leases by the Lessor

Discount Rate
u Implicit rate should be used to determine the
present value of the payments.

u Defined as the discount rate that, at

commencement of the lease, causes the present
value of the lease payments and unguaranteed
residual value to be equal to the fair value of
the leased asset.

21- LO 3
47
 Alternative Use Test

If at the end of the lease term the lessor does not

have an alternative use for the asset, the lessee
classifies the lease as a finance lease.

The assumption is that the lessee uses all the

benefits from the leased asset and therefore the
lessee has essentially purchased the asset.

21- LO 3
48
 Classification of Leases by the Lessor

Accounting Measurement and Presentation

For a sales-type lease,
l the lessor accounts for the lease in a manner
similar to the sale of an asset.

l the lessor generally records a Lease Receivable and

eliminates the leased asset.

l the lease receivable is computed as shown.

21- ILLUSTRATION 21.19 LO 3

49
 Finance (Sales-Type) Lease Example

Illustration: CNH Financial Services Corp. (a subsidiary of CNH) and

Ivanhoe Construction sign a lease agreement dated January 1, 2019,
that calls for CNH to lease a backhoe to Ivanhoe beginning January 1,
2019. The terms and provisions of the lease agreement, and other
pertinent data, are as follows.
• The term of the lease is five years. The lease agreement is non-
cancelable, requiring equal rental payments at the beginning of each
year (annuity-due basis).
• The backhoe has a fair value at the commencement of the lease of
€100,000, an estimated economic life of five years, and a
guaranteed residual value of €5,000 (which is less than the
expected residual value of the backhoe at the end of the lease).
Further, assume the underlying asset (the backhoe) has an €85,000
cost to the dealer, CNH.
• The lease contains no renewal options. The backhoe reverts to CNH
at the termination of the lease.
21- LO 3
50 • Collectibility of payments by CNH is probable.
 Finance (Sales-Type) Lease Example

Illustration: CNH Financial Services Corp. (a subsidiary of CNH) and

Ivanhoe Construction sign a lease agreement dated January 1, 2019,
that calls for CNH to lease a backhoe to Ivanhoe beginning January 1,
2019. The terms and provisions of the lease agreement, and other
pertinent data, are as follows.
• CNH sets the annual rental payment to earn a rate of return of 4
percent per year (implicit rate) on its investment as shown in
Illustration 21.20.

ILLUSTRATION 21.20
Lease Payment Calculation

21- LO 3
51
 Finance (Sales-Type) Lease Example

The lease meets the criteria for classification as a

finance (sales-type) lease because
1. Lease term is equal to the economic life of the
asset.

2. Present value of the lease payments is €100,000*,

which is 100% (greater than or equal to 90%) of
the fair value of the backhoe.

That is, Ivanhoe will consume substantially the entire

underlying asset over the lease term.

21- LO 3
52
 Finance (Sales-Type) Lease Example

CNH computes the lease receivable as shown. ILLUSTRATION 21.22

Lease Receivable
Calculation

The journal entries on January 1, 2019, are as follows.

Lease Receivable 100,000
Sales Revenue 100,000
Cost of Goods Sold 85,000
Inventory 85,000
21- LO 3
53
 Finance (Sales-Type) Lease Example

ILLUSTRATION 21.23
Lease Amortization Schedule

21- LO 3
54
 ILLUSTRATION
21.23

On January 1, 2019, CNH records receipt of the first year’s

lease payment as follows.
Ivanhoe records accrued interest on December 31, 2019
Cash 20,711.11
Lease Receivable 20,711.11
21- * rounding LO 3
55
 ILLUSTRATION
21.23

On December 31, 2019, CNH recognizes the interest

revenue on the lease receivable during the first year through
the following entry.
Lease Receivable 3,171.56
Interest Revenue 3,171.56
21- * rounding LO 3
56
 Finance (Sales-Type) Lease Example

The balance sheet as it relates to lease transactions at

December 31, 2019.

ILLUSTRATION
21.24
Balance Sheet
Presentation

On its December 31, 2019, income statement, CNH

reports,

ILLUSTRATION
21.25
Income Statement
presentation
21- LO 3
57
 ILLUSTRATION
21.23

The following entries record receipt of the second year’s lease

payment and recognition of the interest revenue in 2020.

Jan. 1 Cash 20,711.11

Lease Receivable 20,711.11
Ivanhoe records accrued interest on December 31, 2019
Dec. Lease Receivable 2,469.97
31 Interest Revenue 2,469.97
21- * rounding LO 3
58
 ILLUSTRATION
21.23

CNH makes the following entry on December 31, 2023.

Ivanhoe records accrued interest on192.19

Lease Receivable December 31, 2019
Lease Revenue 192.19

21- * rounding LO 3
59
 ILLUSTRATION
21.23

At January 1, 2024, when the leased asset is returned to

CNH.
Inventory 5,000
Lease Receivable 5,000

21- * rounding LO 3
60
 Lessor—Guaranteed Residual Value

In the Ivanhoe/CNH example, Ivanhoe guaranteed a residual

value of €5,000. In computing the amount to be recovered
from the rental payments, the present value of the residual
value was subtracted from the fair value of the backhoe to
arrive at the amount to be recovered by the lessor.
Illustration 21.26 shows this computation.
ILLUSTRATION 21.26

Computation is same whether residual value is guaranteed or

unguaranteed.
21- LO 3
61
 Lessor—Unguaranteed Residual Value

In this case, there is less certainty that the unguaranteed

residual portion of the asset has been “sold.”
u The lessor recognizes sales revenue and cost of goods
sold only for the portion of the asset for which
recovery is assured.

u Both sales revenue and cost of goods sold are reduced

by the present value of the unguaranteed residual
value.

u The gross profit computed will still be the same

amount as when a guaranteed residual value exists.

21- LO 3
62
 Lessor—Unguaranteed Residual Value

To compare a sales-type lease with a guaranteed

residual value to one with an unguaranteed residual
value, assume the same facts as in the CNH/Ivanhoe
lease situation. That is:

1. The sales price is €100,000.

2. The expected residual value is €5,000 (the present

value of which is €4,109.65).

3. The leased equipment has an €85,000 cost to the

dealer, CNH.

21- LO 3
63
 Lessor—Unguaranteed Residual Value

Computation of Lease Amounts by CNH

Financial—Sales-Type Lease

ILLUSTRATION 21.27
Computation of Lease Amounts by CNH—Sales-Type Lease

21- LO 3
64
 ILLUSTRATION 21.28
21- Entries for Guaranteed and Unguaranteed Residual Values — Sales-Type Lease LO 3
65
 Lessor Accounting for Operating
Leases
The following data relates to a lease agreement between
Hathaway Disposal Ltd. and M&S for the use of one of Hathaway’s
standard cardboard compactors. Information relevant to the lease
is as follows.
• The term of the lease is three years. The lease agreement is
non-cancelable, requiring three annual rental payments of
£17,620.08, with the first payment on January 1, 2019
(annuity-due basis).
• The compactor has a cost and fair value at commencement of
the lease of £60,000, an estimated economic life of five years,
and a residual value at the end of the lease of £12,000
(unguaranteed).
• The lease contains no renewal options. The compactor reverts to
Hathaway at the termination of the lease.
• The implicit rate of the lessor is known by M&S. Traylor’s
21- LO 3
66 incremental borrowing rate is 6 percent. Hathaway sets the
 Lessor Accounting for Operating Leases

Hathaway classifies the lease as an operating lease because

none of the finance lease tests are met.

ILLUSTRATION 21.30
Lease Classification Tests
21- LO 3
67
 Lessor Accounting for Operating Leases

Under the operating method, Hathawary (the lessor)

u continues to recognize the asset on its statement of

financial position and recognizes lease revenue
(generally on a straight-line basis) in each period.

u continues to depreciate the leased asset.

21- LO 3
68
 Lessor Accounting for Operating Leases

To illustrate the operating method for the

Hathaway/M&S lease, Hathaway records the lease
payment on a straight-line basis on January 1, 2019,
2020, and 2021, as follows.
Cash 17,620.08
Unearned Lease Revenue 17,620.08

On December 31, 2019, 2020, and 2021, Hathaway

records the recognition of the revenue each period as
follows.
Unearned Lease Revenue 17,620.08
Lease Revenue 17,620.08

21- LO 3
69
 Lessor Accounting for Operating Leases

Hathaway also records depreciation expense on the leased

equipment (assuming double-declining-balance, given a
cost basis of £60,000, and a five-year economic life), as
follows.
Depreciation Expense (£60,000 × 40%) 24,000.00
Accumulated Depreciation—Equipment 24,000.00

Hathaway records other costs related to the lease

arrangement, such as insurance, maintenance, and taxes
in the period incurred.

21- LO 3
70
 LEARNING OBJECTIVE 4
Special Lease Discuss the accounting and

Accounting Problems
reporting for special features
of lease arrangements.

1. Other lease adjustments.

2. Presentation, disclosure, and analysis.

21- LO 4
71
 Special Lease Accounting Problems

Other Lease Adjustments

Executory Costs are normal expenses associated
with owning a leased asset, such as property
insurance and property taxes.
u Executory costs included in the fixed payments
required by the lessor should be included in lease
payments for purposes of measuring the lease
liability.

u Payments by the lessee made directly to the

taxing authority or insurance provider are
considered variable payments and are expensed
21- as incurred. LO 4
72
 Special Lease Accounting Problems

Other Lease Adjustments

Lease Prepayments and Incentives
Companies adjust the right-of-use asset for any lease
prepayments, lease incentives, and initial direct costs
made prior to or at the commencement date.
1. Lease prepayments made by the lessee increase the
right-of-use asset.
2. Lease incentive payments made by the lessor to the
lessee reduce the right-of-use asset.
3. Initial direct costs incurred by the lessee (discussed in
the next section) increase the right-of-use asset.

21- LO 4
73
 Special Lease Accounting Problems

Other Lease Adjustments

Initial direct costs are incremental costs of a lease that
would not have been incurred had the lease not been
executed.
Examples of costs included and excluded from initial direct 21.33
ILLUSTRATION
Initial Direct Costs
costs from the lessee and lessor side.

21- LO 4
74
 Special Lease Accounting Problems

Other Lease Adjustments

Initial direct costs incurred by the lessee are included in
the cost of the right-of-use asset but are not recorded as
part of the lease liability.

Lessor accounting for initial direct costs depends on the

type of lease.
• For operating leases, a lessor defers the initial direct
costs and amortizes them as expenses over the term of
the lease.

• For finance leases, the lessor expenses initial direct costs

at lease commencement (in the period in which it
21- recognizes the profit on the sale). LO 4
75
 Special Lease Accounting Problems

Presentation, Disclosure, and Analysis

Presentation
Summary of how the lessee reports the information
related to finance and operating leases in the financial
statements.

ILLUSTRATION 21.35
Presentation in Financial Statements—Lessee

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 Presentation, Disclosure, and
Analysis
Presentation
Summary of how the lessor reports the information
related to sales-type and operating leases in the financial
statements.

ILLUSTRATION 21.36
Presentation in Financial Statements—Lessor

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 Presentation, Disclosure, and
Analysis
Disclosure
Lessees and lessors must also provide additional qualitative
and quantitative disclosures to help financial statement
users assess the amount, timing, and uncertainty of future
cash flows. Qualitative disclosures to be provided by both
lessees and lessors are summarized as shown.

ILLUSTRATION 21.37
Qualitative Lease Disclosures

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 Presentation, Disclosure, and
Analysis
Disclosure
This illustration presents the type of quantitative
information that should be disclosed for the lessee.

ILLUSTRATION 21.38
Lessee Quantitative Disclosures

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 Presentation, Disclosure, and
Analysis
Disclosure
This illustration presents the type of quantitative
information that should be disclosed for the lessor.

ILLUSTRATION 21.40
Lessor Quantitative Disclosures

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 Presentation, Disclosure, and
Analysis
Analysis
With the increase in the assets and liabilities, a number of
financial metrics used to measure the profitability and
solvency of companies will change.
• Return on assets will decrease.

• Earnings before interest, taxes, and depreciation and

amortization (EBIDTA), which likely will require some
adjustments as companies depreciate right-of-use
assets and record interest expense.

• Debt to equity ratio will increase, and the interest

coverage ratio will decrease.

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 APPENDIX 21A Sale-Leasebacks

LEARNING OBJECTIVE 5
Describe the lessee’s accounting for sale-leaseback transactions.

A company (the seller-lessee) transfers an asset to

another company (the buyer-lessor) and then leases that
asset back from the buyer-lessor.

ILLUSTRATION 21A.1
Sale-Leaseback

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 APPENDIX 21A Sale-Leasebacks

Why do companies like Darden Restaurants engage in

sale-leaseback transactions?
1. Darden can use the cash that otherwise would be tied
up in property to expand its operations. At the same
time, it continues to use the property through the lease
term.

2. Darden can structure the lease arrangement so issues

such as repurchase provisions, refinancing issues, and
conventional financing costs are minimized.

3. Darden may receive a tax advantage in that entire

rental payments are tax-deductible, whereas under a
conventional financing, only interest and depreciation
21- can be deducted. LO 5
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 APPENDIX 21A Sale-Leasebacks

The advantages to Golden Gate Capital (buyer-lessor):

u It generally can earn a higher rate of return under a
sale-leaseback than under traditional financing.

u During the lease term, Golden Gate is protected from a

downturn in the real estate market and may have an
inflation hedge, provided the property appreciates in
value.

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 APPENDIX 21A Sale-Leasebacks

Accounting Issues In Sale-Leaseback

Transactions
The accounting issue is whether the transaction is a
sale or a financing.
u If control has passed from seller to buyer, then a
sale has occurred.

u If control has not passed from seller to buyer, the

transaction is recorded as a financing (often
referred to as a failed sale).

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 APPENDIX 21A Sale-Leasebacks

Sale Transaction
In a sale, gain or loss recognition is appropriate.
Darden then records the transaction as follows.
1. Increases cash and reduces the carrying value of
the asset to zero (referred to as derecognizing the
asset).

2. Recognizes a gain or loss as appropriate.

3. Accounts for the leaseback in accordance with

lease accounting guidance used in this chapter.

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 APPENDIX 21A Sale-Leasebacks

Sale Transaction
For example, assume that Stora Enso (FIN) sells one of
its buildings having a carrying value of €580,000
(building €800,000 less accumulated depreciation
€220,000) to Deutsche Bank (DEU) for €623,110.
It then leases the building back from Deutsche Bank
for €50,000 a year, for eight of the building’s 15
years of remaining economic life. Assume that the
present value of these lease payments is equal to
€310,000, such that the lease is classified as an
operating lease by Deutsche Bank.
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 APPENDIX 21A Sale-Leasebacks

Sale Transaction
Stora Enso makes the following entries to record the
sale-leaseback.

Cash 623,110
Accumulated Depreciation—Buildings 220,000
Buildings 800,000
Gain on Disposal of Plant Assets 43,110
(€623,110 −
€580,000)

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 APPENDIX 21A Sale-Leasebacks

Sale Transaction
In addition, Stora Enso makes an entry to record the
operating lease from Deutsche Bank as follows.

Right-of-Use Asset 310,000

Lease Liability 310,000

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 APPENDIX 21A Sale-Leasebacks

Financing Transaction (Failed Sale)

Stora Enso does not record a sale in the above
transaction if the lease from Deutsche Bank is classified
as a finance lease. In a financing (failed sale), Scott:
u Does not reduce the carrying value of the building.
u Depreciate the building as if it was the legal owner.
u Recognizes the sale proceeds from Deutsche Bank as a
financial liability.

The entry to record the financing is as follows.

Cash 623,110
Notes Payable 623,110
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 APPENDIX 21A Sale-Leasebacks

Sale-Leaseback Example
Japan Airlines (JAL) (JPN) on January 1, 2019, sells a used Boeing
757 having a carrying amount on its books of $30,000,000 to
CitiCapital for $33,000,000. JAL immediately leases the aircraft back
under the following conditions:
• The term of the lease is seven years. The lease agreement is non-
cancelable, requiring equal rental payments of $4,881,448 at the
end of each year (ordinary annuity basis), beginning December
31, 2019.
• The lease contains no renewal or purchase options. The plane
reverts to CitiCapital at the termination of the lease.
• The aircraft has a fair value of $33,000,000 on January 1,
2019, and an estimated remaining economic life of 10 years. The
residual value (unguaranteed) at the end of the lease is
21- $13,000,000. LO 5
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 Sale-Leaseback Example
Applying the classification tests, the lease-back of the
airplane is classified as an operating lease because none of
the sales-type lease criteria are met, as indicated in
Illustration 21A.3.

ILLUSTRATION 21A.3
Lease Classification Tests
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 Sale-Leaseback Example
This arrangement is accounted for as a sale because the
leaseback does not transfer control of the asset back to
JAL; only the right-of-use for seven years is granted
through the lease.

Partial Lease Amortization Schedule

ILLUSTRATION 21A.4
Comparative Entries for Sale-Leaseback for Lessee and
Lessor

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ILLUSTRATION 21A.4
Comparative Entries for Sale-Leaseback for Lessee and
Lessor
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 DIRECT FINANCING LEASE
APPENDIX 21B
(LESSOR)

LEARNING OBJECTIVE 6
Apply lessee and lessor accounting to finance and operating leases.

Lease Terms: Scenario 1

Parker Shipping Ltd. (lessee) leases a standard hydraulic lift
from Stoughton Trailers AG (the lessor). The lease, signed on
January 1, 2019, specifies that Stoughton grants right-of-use
of the lift to Parker.

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 Lease Terms: Scenario 1

The lease terms are as follows:

• Lease is non-cancelable, term of four years, equal rental
payments of €11,182.24 at the beginning of each year
(annuity-due).
• Lift has a fair value of €40,000, economic life of four
years, and no residual value.
• Cost of lift on Stoughton’s books is €30,000.
• No renewal options. Lift reverts to Stoughton. Implicit21B.1
ILLUSTRATION
Lease Payment Calculation
rate of lessor is 8 percent and is known by Parker.

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 Lease Terms: Scenario 1

Stoughton (lessor) evaluates the lease classification tests as

indicated.

ILLUSTRATION 21B.2
Lease Classification Tests
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 Lease Terms: Scenario 1

Lessee/Lessor Accounting

ILLUSTRATION 21B.3 *Rounded by €0.06.

Lease Liability Amortization Schedule

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 Scenario 1

ILLUSTRATION 21B.4
Lessee/Lessor Entries for Finance/Sales-Type Lease
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 Scenario 1

ILLUSTRATION 21B.4
Lessee/Lessor Entries for Finance/Sales-Type Lease

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 Scenario 1

ILLUSTRATION 21B.4
Lessee/Lessor Entries for Finance/Sales-Type Lease

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 Lease Terms: Scenario 2

The lease terms are as follows:

• Lease is non-cancelable, term of four years, equal rental
payments of €9,538.39 at the beginning of each year
(annuity-due).
• Lift has a fair value of €40,000, economic life of six
years, and residual value of €80,000 (unguaranteed).
• Cost of lift on Stoughton’s books is €30,000.
• No renewal options. Lift reverts to Stoughton. Implicit21B.5
ILLUSTRATION
Lease Payment Calculation
rate of lessor is 8 percent and is known by Parker.

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 Lease Terms: Scenario 2

Stoughton (lessor) evaluates the lease classification tests as

indicated.

ILLUSTRATION 21B.6
Lease Classification Tests
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 Lease Terms: Scenario 2

Lessee Accounting
Parker makes the following entry to record this lease and
the first payment.
January 1, 2019

Right-of-Use Asset 34,119.76

Lease Liability 34,119.76

Lease Liability 9,538.39

Cash 9,538.39

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 Lease Terms: Scenario 2

Lessee Accounting

*Rounded by €0.02.
ILLUSTRATION 21B.7
Lease Amortization Schedule—Lessee

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 Scenario 2

ILLUSTRATION 21B.8
Lessee Entries for Finance Lease

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 Scenario 2

ILLUSTRATION 21B.8
21-
Lessee Entries for Finance Lease
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 Scenario 2

ILLUSTRATION 21B.8
Lessee Entries for Finance Lease

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 Scenario 2

ILLUSTRATION 21B.8
Lessee Entries for Finance Lease

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 Scenario 2

Lessor Accounting—Operating Lease

Stoughton classifies the lease as an operating lease because
none of the sales-type lease criteria are met.

ILLUSTRATION 21B.9
Lessor Entries for Operating Lease
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 GLOBAL ACCOUNTING
INSIGHTS
LEARNING OBJECTIVE 7
Compare the accounting for leases under IFRS and U.S. GAAP.

Relevant Facts
Following are the key similarities and differences between U.S. GAAP
and IFRS related to leases.
Similarities

u Both GAAP and IFRS share the same objective of recording

leases by lessees and lessors according to their economic
substance—that is, according to the definitions of assets and
liabilities.
u Much of the terminology for lease accounting in IFRS and
GAAP is the same.
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 GLOBAL ACCOUNTING
INSIGHTS
Relevant Facts
Similarities

u Both GAAP and IFRS require lessees to recognize a right-of-

use asset and related lease liability for leases with terms longer
than one year.
u Under both IFRS and GAAP, lessors use the same general
criteria (consistent with the recent standard on revenue) to
determine if there is transfer of control of the underlying asset
and if lessors classify leases as sales-type or operating.
u GAAP and IFRS use the same lessor accounting model for
leases classified as sales-type or operating.
u GAAP and IFRS have similar qualitative and quantitative
disclosure requirements for lessees and lessors.
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 GLOBAL ACCOUNTING
INSIGHTS
Relevant Facts
Differences

u U.S. GAAP continues to use a classification test for lessees

under ASC 842. Thus, lessees account for some leases using the
finance lease method. Leases classified as operating leases
under U.S. GAAP will be accounted for differently compared
to IFRS
u IFRS allows alternative measurement bases for the right-of-
use asset (e.g., the revaluation model, in accordance with IAS
16, Property, Plant and Equipment).
u While both U.S. GAAP and IFRS have a short-term lease
exception, U.S. GAAP does not have the additional lessee
recognition and measurement exemption for leases of assets of
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 GLOBAL ACCOUNTING
INSIGHTS
Relevant Facts
Differences

u IFRS 16 includes explicit guidance on collectibility of the lease

payments by lessors and amounts necessary to satisfy a
residual value guarantee.
u U.S. GAAP distinguishes between sales-type and direct
financing leases for lessors (which defers gross profit on direct
financing leases). Therefore, IFRS 16 permits recognition of
selling profit on direct financing leases at lease
commencement.

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 GLOBAL ACCOUNTING
INSIGHTS
On the Horizon
Lease accounting is one of the areas identified in the IASB/FASB
Memorandum of Understanding. The Boards have developed rules
based on “right-of-use” (ROU) which require that all leases with
terms longer than one year be recorded on the statement of
financial position (balance sheet). The IASB has decided on a single
approach for lessee accounting. Under the IASB approach, a lessee
accounts for all leases as finance leases, recognizing depreciation of
the ROU asset separately from interest on the lease liability. The
FASB reached a different conclusion on the expense recognition for
operating-type leases. Under the FASB model, the income effects
will reflect a straight-line expense pattern, reported as a single
total lease expense. The Boards are generally converged with respect
to lessor accounting.
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