Lease Accounting

A lease is a contractual agreement between a lessor and a lessee. This arrangement gives the
lessee the right to use specific property, which is owned by the lessor, for a specified period
of time. In return for the use of the property, the lessee makes rental payments over the lease
term to the lessor.
Aristotle once said, “Wealth does not lie in ownership but in the use of things!”
Clearly, many global companies have decided that Aristotle is right, as they have become
heavily involved in leasing assets rather than owning them.
A lease is a contract, or part of a contract, that 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 advantages of lease transactions for lessees are: (1) 100 percent
financing, (2) protection against obsolescence, (3) flexibility, and (4) less costly financing.
The benefits for lessors are: (1) profitable interest margins, (2) stimulation of product sales,
(3) tax benefits and efficient tax sharing, and (4) residual value profits.
For all leases, the lessee records a right-of-use asset and related liability at the
commencement of the lease. The lease liability is computed as the present value of the lease
payments. The asset representing the right-of-use of the underlying asset (i.e., the right-of-
use asset) is equal to the lease liability. The lessee recognizes interest expense on the lease
liability over the life of the lease using the effective-interest method and records depreciation
expense on the right-of-use asset (generally on a straight-line basis).
Low-Value Leases. For leases of underlying assets with values of $5,000 or less, rather than
recording a right-of-use asset and lease liability, a lessee may elect to expense the lease
payments as incurred.
Short-Term Leases. A short-term lease is a lease that, at the commencement date, has a
lease term of 12 months or less. Rather than recording a right-of-use asset and lease liability,
lessees may elect to forego recognition of a right-of-use asset and lease liability and expense
the lease payments as incurred.
Whether the estimated residual value is guaranteed or unguaranteed is of both economic
and accounting consequence to the lessee: (1) If it is probable that the expected residual
value is equal to or greater than the guaranteed residual value, the lessee should not include
the guaranteed residual value in the computation of the lease liability. (2) If it is probable that
the expected residual value is less than the guaranteed residual value, the present value of the
difference between the expected and guaranteed residual values should be included in
computation of the lease liability. (3) The lessee does not include the unguaranteed residual
value in the computation of the lease liability.
Bargain Purchase Option. A bargain purchase option increases the present value of the
lease payments by the present value of the option price for the lessee.
In computing annual depreciation of the right-of-use asset with this type of option, the lessee
uses the economic life of the underlying asset.
The largest group of leased equipment involves information technology equipment, followed
by assets in the transportation area (trucks, aircraft, rail), and then construction and
agriculture.
Who are the lessors that own the property being leased? They generally fall into one of three
categories:
1. Banks.
2. Captive leasing companies. 3. Independents
Lease Accounting

Explain the accounting for leases by lessees.

A lease is defined as a “contract, or part of a contract, that 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.” A lease therefore conveys the use of an asset from one party
(the lessor) to another (the lessee) without transferring ownership. Accounting for lease
transactions is controversial, as the following example illustrates.
The IASB now requires lessees to capitalize all leases. The only exceptions to the
capitalization requirement are for leases covering a term of less than one year or for a lease
of property with a value less than $5,000. The IASB indicates that the right to use property
under the terms of the lease is an asset, and the lessee’s obligation to make payments under
the lease is a liability. As a result, Air France records the right-of-use of the airplane as an
asset on its statement of financial position. It also records a liability for its obligation to make
payments under the lease.
Views on Lease Capitalization
Once the lease is recorded, the lessee recognizes interest expense on the lease liability over
the life of the lease using the effective-interest method and records depreciation expense on
the right-of-use asset. This accounting, referred to as the finance lease method, is applied
whether the lease arrangement is effectively a purchase of the underlying asset (Air France’s
lease with ILFC above) or when the lessee obtains control of only the use of the
underlying asset but not the underlying asset itself. For example, a lease may convey use of
one floor of an office building for five years. At the end of the lease, the lessee vacates the
floor and the lessor can then lease the floor to another tenant. In this situation, the lease
conveys right-of-use but not ownership. However, lessee accounting for leases that transfer
ownership or transfer control is the same
Measurement of the Lease Liability and Lease Asset
As indicated, at commencement of the lease, lessees record a right-of-use asset and lease
liability. The lease liability is computed as the present value of the lease payments. The asset
representing the right-of-use of the underlying asset (i.e., the right-of-use asset) is equal to
the lease liability.3 Measurement of the lease liability is based on the lease term, lease
payments, and discount rate.
Lease Payments
The lease payments generally include the following:
1. Fixed payments. These are the rental payments that are specified in the lease agreement
and fixed over the lease term.
2. Variable payments that are based on an index or a rate.
Including Variable Lease Payments
Facts: On January 1, 2022, Jose Shipping leases an airplane for 6 years. The
annual lease payments are R$1,000,000 per year, payable at the beginning of
each year (annuity-due basis). In addition, the lease agreement specifies that the
lease payment increases by R$30,000 every year.
Question: What are the lease payments in 2023?
Solution: On January 1, 2023, the lease payment is R$1,030,000 (R$1,000,000
Lease Accounting

+ R$30,000), which is considered a variable payment. Given that the amount of the
variable payment is known from year to year (the rate is set at commencement of
the lease and in substance fixed), such variable payments are included in
calculating the present value of the lease liability.
Variable Lease Payments
Facts: Assume the same information except that the lease payments are
adjusted each year by a change in a price index.
Question: If the price index is 100 at January 1, 2022, and
increases to
104 on January 1, 2023, what is the payment on January 1, 2023?

Solution: The variable payment on January 1, 2023, is R$1,040,000 (R$1,000,000 × 1.04).

Because the amount of the variable payment from year to year is not known at the lease
commencement date, this payment is not included in determining the present value of the
lease liability. This additional payment (R$40,000) is recognized as an expense in the period
it is incurred.
Similarly, when lease payments vary with a performance measure (e.g., sales at a store
location, asset usage), the variable amounts will be expensed in the period incurred.

Analyzing a Termination Option

Facts: Cabrera Company leases a building and land from Worldwide Leasing for 6 years with
monthly payments of $10,000. The lease contract allows Cabrera to terminate the lease after 2
years for a total payment of $140,000. At the commencement of the lease, it is reasonably certain
that Cabrera will not continue the lease beyond 2 years.
Question: What are Cabrera’s lease payments?
Solution: In this case, Cabrera should include the cost of the termination option in its calculation
of the present value of its lease liability. The total lease payments are therefore $380,000
[($10,000 × 24) + $140,000].

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, 2022, that calls for CNH to lease a backhoe to Ivanhoe beginning January 1, 2022.
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 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 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.
Lease Accounting

 CNH sets the annual rental rate to earn a rate of return of 4 percent per year;
Ivanhoe is aware of this rate.
Ivanhoe computes the lease liability and the amount capitalized as a right-of-use asset as
the present value of the lease payments, as shown below:
Capitalized amount = €20,711.11 × Present value of an annuity due of 1 for 5 periods at
4%
= €20,711.11 × 4.62990 (PVF-AD5,4%) = €95,890.35

Present Value of Lease Payments

Note that the present value measurement does not include the residual value guarantee. That
is, Ivanhoe includes only the expected residual value probable of being owed under the
residual value guarantee. Because Ivanhoe believes that it is probable that the expected
residual value will be greater than the guaranteed residual value, the guaranteed residual
value is not included in the measurement of the lease liability. 8
Ivanhoe uses CNH’s implicit interest rate of 4 percent instead of its incremental borrowing
rate of 5 percent because the implicit rate is known to Ivanhoe. 9
Ivanhoe records the lease on its books as follows.
January 1, 2022
Right-of-Use Asset----------------- 95,890.35
Lease Liability----------------------------------- 95,890.35
Note that Ivanhoe records the obligation at the net amount of €95,890.35 (the present value
of the lease payments) rather than at the gross amount of €103,555.55 (€20,711.11 × 5).10
Ivanhoe then records the first lease payment as follows.
January 1, 2022
Lease Liability ------------------20,711.11
Cash ---------------------------------------------------------20,711.11

The annual interest expense, applying the effective-interest method, is a

function
of the outstanding liability as shown in the lease amortization schedule
in the following illustration

Ivanhoe Mines
Lease Amortization Schedule
Annuity-Due Basis
Date Annual lease Interest (4%) Reduction of Lease
payment on Liability Lease Liability
Liability

(a) (b) (c)

(d)
1/1/22
€95,890.35 1/1/22 € 20,711.11 € –0– €
20,711.11 75,179.24
Lease Accounting

1/1/23 20,711.11 3,007.17 17,703.94

57,475.30
1/1/24 20,711.11 2,299.01 18,412.10
39,063.20
1/1/25 20,711.11 1,562.53 19,148.58
19,914.62
1/1/26 20,711.11 796.49* 19,914.62
0.00
€103,555.55 €7,665.20 €95,890.35
a. Lease payment as required by lease.
b. Four percent of the preceding balance of (d) except for 1/1/22; since this is an annuity due,
no time has elapsed at the date of the first payment and therefore no interest has accrued.
c. (a) minus (b).
d. Preceding balance minus (c).
Each lease payment of €20,711.11 consists of two elements: (1) a reduction of the lease
liability and (2) a financing cost (interest expense).11 The total financing cost (interest
expense) over the term of the lease is €7,665.20. This amount is the difference between the
present value of the lease payments (€95,890.35) and the actual cash disbursed
(€103,555.55). Ivanhoe records interest expense for the first year of the lease as follows.
December 31, 2022
Interest Expense--------------------------- 3,007.17
Lease Liability---------------------------------------------3,007.17
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, 2022.
Depreciation Expense -----------------------19,178.07
Right-of-Use Asset (€95,890.35 ÷ 5 years) ------------------19,178.07
shows the presentation of the lease assets and liabilities sections as they relate to lease
transactions at December 31, 2022, assuming Ivanhoe chose to present right-of-use assets
and lease liabilities separately from other assets and liabilities on the statement of financial
position.

Non-current assets
Right-of-use assets (€95,890.35 − €19,178.07 ) ------------- €76,712.28
Current liabilities
Lease liability (€3,007.17 + €17,703.94) -----------------------€20,711.11
Non-current liabilities
Lease liability-------------------------------------------------------- 57,475.30

In the CNH/Ivanhoe lease just discussed, the residual value was guaranteed by the lessee.
This guaranteed residual value did not affect the computation of the liability, however,
because it was probable that the expected residual value was greater than the guaranteed
residual value. If the expected residual value is greater than the guaranteed residual value,
then Ivanhoe simply returns the equipment to CNH. However, if the expected residual value
Lease Accounting

is less than the guaranteed residual value, Ivanhoe must record a loss on the lease to cover
this deficiency
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.
shows the computation of the lease liability/right-of-use asset for Ivanhoe in this situation.
Ivanhoe’s Capitalized Amount (4% Rate)
Annuity-Due Basis, Including Guaranteed Residual Value
Present value of five annual rental payments (€20,711.11 × 4.62990
(PVF-AD5,4%))---------------------------------------------------------------------------€95,890.35*
Present value of probable residual value payment of €2,000 due 5
years after date of commencement (€2,000 × .82193 (PVF5,4%)) -----------------1,643.86
Lessee’s lease liability/right-of-use asset -------------------------------------------- € 97,534.21
Ivanhoe makes the following entries to record the lease and the first payment.
January 1, 2022
Right-of-Use Asset------------------------------ 97,534.21
Lease Liability -----------------------------------------------------------97,534.21
Lease Liability-------------------------------------- 20,711.11
Cash -----------------------------------------------------------------------20,711.11
Ivanhoe prepares a lease amortization schedule to show interest expense and related
amortization of the lease liability over the five-year period. The schedule, shown in
Illustration 21.11, is based on an expected residual value payment of €2,000 (€5,000 −
€3,000) at the end of five years
Ivanhoe Mines
Lease Amortization Schedule
Annuity-Due Basis
Date Annual lease Interest (4%) on Reduction of Lease liability
payment liability lease liability
(a) (b) (c) (d)
1/1/22 €97,534.21
1/1/22 € 20,711.11 -0- €20,711.11 76,823.10
1/1/23 20,711.11 3072.92 17638.19 59,184.91

1/1/24 20,711.11 2,367.40 18,343.71 40,841.20

1/1/25 20,711.11 1,633.65 19,077.46 21,763.74
1/1/26 20,711.11 870.55 19,840.56 1,923.18
1/1/27 2,000.00 76.82* 1,923.18 0.00
€105,555.55 €8,021.34 €97,534.21
a. Lease payment as required by lease.
Lease Accounting

b. Four percent of the preceding balance of (d) except for 1/1/22; since
this is an annuity due, no time has elapsed at the date of the first
payment and therefore no interest has accrued.
c. (a) minus (b).
d. Preceding balance minus (c).
shows, in comparative form, Ivanhoe’s entries for the first two years of the lease when:
1. Ivanhoe expects to pay €2,000 at the end of the lease related to the guaranteed residual
value ().
2. Ivanhoe does not expect to owe an additional payment for the guaranteed residual value