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 (capital lease) leases. This step-by-step guide covers 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 (also called capital leases). In order to differentiate between the two, one must consider how fully the risks and rewards associated with ownership of the asset have been transferred to the lessee from the lessor.
If these risks and rewards have been fully transferred, it is called a financing lease under IFRS Standards. Under ASPE, financing leases are called capital leases. Otherwise, it is an operating lease, which is basically the same as a landlord and renter contract.
Whether the risks and rewards have been fully transferred can be unclear sometimes, thus IFRS outlines several criteria to distinguish between the two leases.
At least one of the following criteria must be met in order to consider the lease a financing lease:
- 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 (typically, the end of the lease term). This option is usually determined at the beginning of the lease.
- The life of the lease is for a significant portion of the useful economic life of the asset (generally, 75% or more).
- The net present value (NPV) of minimum lease payments is at least 90% of the asset’s fair value.
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 of 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 the same amount of care as if it were 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.
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, to be made 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 finance lease criteria is met and during the lease, the risks and rewards of the asset have been fully transferred. We have determined the proper lease accounting.
Step 2: Lease amortization schedule
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 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
This has been a guide to lease accounting and understanding operating leases, capital leases, and the debits and credits to account for them. You can read more about lease accounting on the IFRS website http://www.ifrs.org/ias-17-leases/
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