Lease Accounting

A guide to accounting for leases

What is a lease?

Leases are contracts in which the property/asset owner allows another party to use the property/asset in exchange for something, usually money or other assets. The two most common types of leases in accounting are operating and financing. This guide will cover all the basics of lease accounting.

 

Operating lease vs financing lease (capital lease)

The two most common types of leases are operating leases and financing leases. In order to differentiate the two, one must consider whether the risks and rewards associated with ownership of the asset have been fully transferred to the lessee from the lessor.

If these risks and rewards have been fully transferred, it is called a financing lease under IFRS. Under ASPE, financing leases are called capital leases. Otherwise, it is an operating lease, which is illustrated in the landlord and renter example above.

Whether the risks and rewards have been fully transferred can be unclear sometimes,  thus IFRS outlines several other criteria to distinguish between the two leases.

 

lease accounting

 

The advantages of leasing

Leasing provides a number of benefits that can be used to attract customers:

  • Payment schedules are more flexible than loan contracts.
  • After-tax costs are lower because tax rates are different for the lessor and the lessee.
  • Leasing involves 100% financing of the price of the asset.
  • For an operating lease, the company will create an expense instead of a liability, allowing the company to obtain financial funding – often referred to as “off-balance sheet financing.”

 

Disadvantages of leasing

One major disadvantage to leasing is the agency cost problem. In a lease, the lessor will transfer all rights to the lessee for a specific period of time, creating a moral hazard issue. Because the lessee who controls the asset is not the owner of the asset, the lessee may not exercise enough care as if it’s his/her own asset. This separation between the asset’s ownership (lessor) and control of the asset (lessee) is referred to as the agency cost of leasing.  This is an important concept in lease accounting.

 

Criteria for operating lease vs capital lease accounting

In addition to the transfer of the risks and rewards associated with ownership, IFRS outlines a few more criteria to meet the attributes of a financing lease or capital lease under ASPE.

At least one of the following criteria must be met:

  • There is a bargain purchase option – an option given to the lessee to purchase the asset at a price lower than its fair value at a future date. This option is usually determined at the beginning of the lease.
  • The life of the lease is a significant portion of the economic life of the asset (generally, 75%).
  • The present value of the minimum lease payments is equal to at least 90% of the fair value of the asset.

 

Lease accounting example and steps

Let’s walk through a lease accounting example. On January 1, 2017, XYZ Company signed an 8-year lease agreement for equipment. Annual payments are $28,500 at the beginning of each year. At the end of the lease, the equipment will revert to the lessor. The equipment has a useful life of 8 years and has no residual value. At the time of the lease agreement, the equipment has a fair value of $166,000. An interest rate of 10.5% and straight-line depreciation are used.

 

Step 1: Identify the type of lease

  • There is no bargain purchase option because the equipment will revert back to the lessor.
  • The life of the lease is 8 years and the economic life of the asset is 8 years. This is 100%.
  • Using a financial calculator, calculate for the PV of the minimum lease payments:
    • N = 8
    • I/YR = 10.5
    • FV = 0
    • PMT = 28,500
    • PV = 164,995
    • Therefore, 164,995/166,000 = 99%

 

Conclusion: This is a financing/capital lease because at least one of the above criteria is met and during the lease, the risks and rewards of the asset have been fully transferred.  We have satisfied the criteria for proper lease accounting.

 

Step 2: Lease amortization schedule

 

OpeningInterestPrincipalClosing
Year BalanceExpensePaymentPaymentBalance
1 $136,495 $14,332 $28,500 $14,168 $122,327
2 122,327 12,844 28,500 15,656 106,671
3 106,671 11,201 28,500 17,299 89,372
4 89,372 9,384 28,500 19,116 70,256
5 70,256 7,377 28,500 21,123 49,133
6 49,132.90 5,158.95 28,500 23,341.05 25,791.86
7 $25,792 $2,708 $28,500 $25,792 $0

 

Step 3: Journal entries

January 1, 2017

DR Equipment            164,995

CR Cash                        28,500

CR Lease Liability       136,495

 

The equipment account is debited by the present value of the minimum lease payments and the lease liability account is the difference between the value of the equipment and cash paid at the beginning of the year.

 

December 31, 2017

DR Depreciation Expense                   20,624

CR Accumulated Depreciation           20,624

 

Depreciation expense must be recorded for the for the equipment that is leased.

 

DR Interest Expense               14,332

CR Interest Payable                14,332

 

January 1, 2018

DR Interest Payable                 14,332

DR Lease Liability                    14,168

CR Cash                                     28,500

 

Additional resources

This has been a guide to lease accounting and understanding operating leases, capital leases, and the debits and credits to account for them.  To keep learning and developing we recommend these additional resources: