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CHAPTER 21
Accounting for Leases
ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)
Topics Questions
Brief Exercises Exercises Problems
Concepts for Analysis
*1. Rationale for leasing. 1, 2, 4 1, 2
*2. Lessees; classification of leases; accounting by lessees.
*3. Disclosure of leases. 19 2, 4, 5, 7, 8
*4. Lessors; classification of leases; accounting by lessors.
*5. Residual values; bargain- purchase options; initial direct costs.
*6. Sale-leaseback. 20 12 15, 16 7
*This material is dealt with in an Appendix to the chapter.
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)
Learning Objectives
Questions Brief Exercises
Exercises
Problems Concepts for Analysis
- Explain the nature, economic substance, and advantages of lease transactions.
- Describe the accounting for leases by lessees.
- Describe the accounting for leases by lessors.
- Describe the accounting and reporting for special feature of lease arrangements.
*5. Describe the lessee’s accounting for sale- leaseback transactions.
ASSIGNMENT CHARACTERISTICS TABLE (Continued)
Item Description
Level of Difficulty
Time (minutes) CA21-1 Lessee accounting and reporting. Moderate 15– CA21-2 Lessor and lessee accounting and disclosure. Moderate 25– CA21-3 Lessee capitalization criteria. Moderate 20– CA21-4 Comparison of different types of accounting by lessee and lessor.
Moderate 15–
CA21-5 Lessee capitalization of bargain-purchase option. Moderate 30– CA21-6 Lease capitalization, bargain-purchase option. Moderate 20–
*CA21-7 Sale-leaseback. Moderate 15–
ANSWERS TO QUESTIONS
**1. The major lessor groups in the United States are banks, captives, and independents. Captives have the point of sale advantage in finding leasing customers; that is, as soon as a parent receives a possible order, a lease financing arrangement can be developed by its leasing subsidiary. Furthermore, the captive (lessor) has the product knowledge which gives it an advantage when financing the parents’ product. The current trend is for captives to focus on the company’s products rather than to do general lease financings.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
**2. (a) Possible advantages of leasing:
- Leasing permits the write-off of the full cost of the assets (including any land and residual value), thus providing a possible tax advantage.
- Leasing may be more flexible in that the lease agreement may contain less restrictive provisions than the bond indenture.
- Leasing permits 100% financing of assets.
- Leasing may permit more rapid changes in equipment, reduce the risk of obsolescence, and pass the risk in residual value to the lessor or a third party.
- Leasing may have favorable tax advantages.
- Potential of off-balance-sheet financing with certain types of leases.
Assuming that funds are readily available through debt financing, there may not be great advantages (in addition to the above-mentioned) to signing a noncancelable, long-term lease. One of the usual advantages of leasing is its availability when other debt financing is unavailable.
(b) Possible disadvantages of leasing:
- In an ever-increasing inflationary economy, retaining title to assets may be desirable as a hedge against inflation.
- Interest rates for leasing often are higher and a profit factor may be included in addition.
- In some cases, owning the asset provides unique tax advantages, such as when bonus depreciation is permitted.
(c) Since a long-term noncancelable lease which is used as a financing device generally results in the capitalization of the leased assets and recognition of the lease commitment in the balance sheet, the comparative effect is not very different from purchase and ownership. Assets leased under such terms would be capitalized at the present value of the future lease payments; this value is probably somewhat equivalent to the purchase price of the assets. Bonds sold at par would be nearly equivalent to the present value of the future lease payments; in neither case would interest be capitalized. The amounts presented in the balance sheet would be quite comparable as would the general classifications; the specific labels (leased assets and lease liability) would be different.
LO: 1, Bloom: C, Difficulty: Moderate, Time: 5-10, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
**3. Lessees have available two lease accounting methods: (a) the operating method and (b) the capital-lease method. Under the operating method, the leased asset remains the property of the lessor with the payment of a lease rental recognized as rental expense. Generally the lessor pays the insurance, taxes, and maintenance costs related to the leased asset. Under the capital-lease method, the lessee treats the lease transaction as if an asset were being purchased on credit; therefore, the lessee: (1) sets up an asset and a related liability and (2) recognizes depreciation of the asset, reduction of the liability, and interest expense.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Questions Chapter 21 (Continued)
**9. From the standpoint of the lessor, leases may be classified for accounting purposes as: (a) operating leases, (b) direct-financing leases, and (c) sales-type leases.
From the standpoint of lessors, a capital lease meets one or more of the following four criteria:
- The lease transfers ownership,
- The lease contains a bargain-purchase option,
- The lease term is equal to 75% or more of the estimated economic life of the property,
- The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90% of the fair value of the property.
And meet both of the following criteria:
- Collectibility of the payments required from the lessee is reasonably predictable, and
- No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor,
Capital leases are classified as direct-financing leases or sales-type leases. All other leases are classified as operating leases. The distinction for the lessor between a direct-financing lease and a sales-type lease is the presence or absence of a manufacturer’s or dealer’s profit or loss.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*10. If the lease transaction satisfies the necessary criteria to be classified as a direct-financing lease, the lessor records a “lease receivable” for the leased asset. The lease receivable is the present value of the minimum lease payments. Minimum lease payments include the rental payments (excluding executory costs), bargain-purchase option (if any), guaranteed residual value (if any) and penalty for failure to renew (if any). In addition, the present value of the unguaranteed residual value (if any) must also be included.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*11. Under the operating method, each rental receipt of the lessor is recorded as rent revenue on the use of an item carried as a fixed asset. The fixed asset is depreciated in the normal manner, with the depreciation expense of the period being matched against the rent revenue. The amount of revenue recognized in each accounting period is equivalent to the amount of rent receivable according to the provisions of the lease. In addition to the depreciation charge, maintenance costs and the cost of any other services rendered under the provisions of the lease that pertain to the current accounting period are charged against the recognized revenue.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, Measurement, AICPA PC: None
*12. Walker Company can use the sales-type lease method if at the inception of the lease a manufacturer’s or dealer’s profit (or loss) exists and the lease meets one or more of the following four criteria: (1) The lease transfers ownership of the property to the lessee, (2) The lease contains a bargain-purchase option, (3) The lease term is equal to 75% or more of the estimated economic life of the property leased, (4) The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90% of the fair value of the leased property.
Both of the following criteria must also be met: (1) Collectibility of the payments required from the lessee is reasonably predictable, and (2) No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Questions Chapter 21 (Continued)
*13. Metheny Corporation should recognize the difference between the fair value (normal sales price) of the leased property at the inception of the lease and its cost or carrying amount (book value) as gross profit in the period the sales-type lease begins and the assets are transferred to the lessee. The balance of the transaction is treated as a direct-financing lease (i.e., interest revenue is earned over the lease term).
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*14. The lease agreement between Alice Foyle, M.D. and Brownback Realty, Inc. appears to be in substance a purchase of property. Because the lease has a bargain-purchase option which transfers ownership of the property to the lessee, the lease is a capital lease. Additional evidence of the capital lease character is that the lessor recovers all costs plus a reasonable rate of return on investment. As a capital lease, the property and the related liability should be recorded at the discounted amount of the future lease payments with that amount being allocated between the land and the building in proportion to their fair values at the inception of the lease. The building should be depreciated over its estimated useful life.
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*15. (a) (1) The lessee’s accounting for a lease with an unguaranteed residual value is the same as the accounting for a lease with no residual value in terms of the computation of the minimum lease payments and the capitalized value of the leased asset and the lease liability. That is, unguaranteed residual values are not included in the lessee’s minimum lease payments.
(2) A guaranteed residual value affects the lessee’s computation of the minimum lease payments and the capitalized amount of the leased asset and the lease liability. The capitalized value is affected initially by the presence of a guaranteed residual value since the present value of the lease liability is now made up of two components—the periodic lease payments and the guaranteed residual value. The amortization of the lease obligation will result in a lease liability balance at the end of the lease period which is equal to the guaranteed residual value. Upon termination of the lease, the lessee may recognize a gain or loss depending on the relationship between the actual residual value and the amount guaranteed.
(b) (1) & (2) The amount to be recovered by the lessor is the same whether the residual value is guaranteed or unguaranteed. Therefore, the amount of the periodic lease payments as set by the lessor is the same whether the residual value is guaranteed or unguaranteed.
LO: 4, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*16. If the estimate of the residual value declines, the lessor must recognize a loss to the extent of the decline in the period of the decline. Taken literally, the accounting for the entire transaction must be revised by the lessor using the changed estimate. The lease receivable is reduced by the amount of the decline in the estimated residual value. Upward adjustments of the estimated residual value are not made.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, Measurement, AICPA PC: None
*17. If a bargain-purchase option exists, the lessee must increase the present value of the minimum lease payments by the present value of the option price. A bargain purchase option also affects the depreciable life of the leased asset since the lessee must depreciate the asset over its economic life rather than the term of the lease. If the lessee fails to exercise the option, the lessee will recognize a loss to the extent of the net book value of the leased asset in the period that the option expired.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, Measurement, AICPA PC: None
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 21-
The lease does not meet the transfer of ownership test, the bargain purchase
test, or the economic life test [(5 years ÷ 8 years) < 75%]. However, it does
pass the recovery of investment test. The present value of the minimum
lease payments ($31,000 X 4.16986* = $129,266) is greater than 90% of the
FV of the asset (90% X $138,000 = $124,200). Therefore, Callaway should
classify the lease as a capital lease.
*Present value of an annuity due of 1 for 5 periods at 10%.
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
BRIEF EXERCISE 21-
Leased Equipment......................................................... 150,
Lease Liability ........................................................ 150,
Lease Liability................................................................ 43,
Cash ........................................................................ 43,
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 21-
Interest Expense ............................................................ 29,
Interest Payable [($300,000 – $53,920) X 12%] ..... 29,
Depreciation Expense ................................................... 37,
Accumulated Depreciation—Capital Leases
($300,000 X 1/8) ................................................ 37,
LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 21-
Interest Payable [($300,000 – $53,920) X 12%] ............ 29,
Lease Liability................................................................ 24,
Cash ........................................................................ 53,
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*Present value of an annuity due of 1 for 3 periods at 8%.
- BRIEF EXERCISE 21-
- Rent Expense 35,
- Cash......................................................................... 35,
- BRIEF EXERCISE 21-
- Lease Receivable (4.99271* X $30,044) 150,
- Cash 30,
- BRIEF EXERCISE 21- LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
- Interest Receivable......................................................... 9,
- Interest Revenue [($150,000 – $30,044) X 8%] 9,
- BRIEF EXERCISE 21- LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
- Cash 15,
- Depreciation Expense 10,
- Accumulated Depreciation ($80,000 X 1/8) 10,
*BRIEF EXERCISE 21-
Cash ................................................................................ 33,
Trucks...................................................................... 28,
Unearned Profit on Sale—Leaseback.................... 5,
Leased Equipment ......................................................... 33,000*
Lease Liability ......................................................... 33,
($8,705 X 3.79079*; $1 difference due to rounding.)
**Present value of an annuity due of 1 for 5 periods at 10%.
Depreciation Expense .................................................... 6,
Accumulated Depreciation—Capital Leases
($33,000 X 1/5) .................................................... 6,
Unearned Profit on Sale—Leaseback ........................... 1,
Depreciation Expense ($5,000 X 1/5) ..................... 1,
Interest Expense ($33,000 X 10%) ................................. 3,
Lease Liability ................................................................ 5,
Cash......................................................................... 8,
LO: 5, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
SOLUTIONS TO EXERCISES
EXERCISE 21-1 (15–20 minutes)
(a) This is a capital lease to Burke since the lease term (5 years) is greater
than 75% of the economic life (6 years) of the leased asset. The lease
term is 83
1
/ 3 % (5 ÷ 6) of the asset’s economic life.
(b) Computation of present value of minimum lease payments:
$8,668 X 4.16986* = $36,
*Present value of an annuity due of 1 for 5 periods at 10%.
January 1, 2017
(c) Leased Equipment ................................. 36,
Lease Liability................................. 36,
Lease Liability ........................................ 8,
Cash ................................................ 8,
December 31, 2017
Depreciation Expense............................ 7,
Accumulated Depreciation—
Capital Leases ............................ 7,
($36,144 ÷ 5 = $7,229)
Interest Expense .................................... 2,
Interest Payable .............................. 2,
[($36,144 – $8,668) X .10]
January 1, 2018
Lease Liability ........................................ 5,
Interest Payable ..................................... 2,
Cash ................................................ 8,
LO: 2, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 21-3 (Continued)
Present value of minimum lease payments
$69,529 X 6.32825* = $440,000**
*Present value of an annuity due of 1 for 10 periods at 12%.
**rounded by $3.
Leased Buildings .............................. 440,
Lease Liability ........................... 440,
Executory Costs ................................. 2,
Lease Liability ................................... 69,
Cash ........................................... 72,
Depreciation Expense ........................... 44,
Accumulated Depreciation—
Capital Leases ....................... 44,
($440,000 ÷ 10)
Interest Expense
(See Schedule 1) ........................... 44,
Interest Payable......................... 44,
Executory Costs ..................................... 2,
Interest Payable ................................ 44,
Lease Liability (See Schedule 1)...... 25,
Cash ........................................... 72,
Depreciation Expense ................................. 44,
Accumulated Depreciation—
Capital Leases ....................... 44,
EXERCISE 21-3 (Continued)
Interest Expense ................................... 41,
Interest Payable ........................ 41,
Schedule 1 KIMBERLY-CLARK CORP.
Lease Amortization Schedule
(Lessee)
Date
Annual
Payment Less
Executory
Costs
Interest (12%)
on Liability
Reduction
of Lease
Liability Lease Liability
LO: 2, 4, Bloom: AN, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 21-4 (20–25 minutes)
Computation of annual payments
Cost (fair value) of leased asset to lessor $160,
Less: Present value of salvage value
(residual value in this case)
$16,000 X .82645*
*(Present value of 1 at 10% for 2 periods) 13,
Amount to be recovered through lease payments $146,
Two periodic lease payments $146,777 ÷ 1.73554** $84,
**Present value of an ordinary annuity of 1 for 2 periods at 10%
EXERCISE 21-5 (15–20 minutes)
(a) Because the lease term is longer than 75% of the economic life of the
asset and the present value of the minimum lease payments is more
than 90% of the fair value of the asset, it is a capital lease to the lessee.
Assuming collectibility of the rents is reasonably assured and no
important uncertainties surround the amount of unreimbursable costs
yet to be incurred by the lessor, the lease is a direct financing lease to
the lessor.
The lessee should adopt the capital lease method and record the leased
asset and lease liability at the present value of the minimum lease pay-
ments using the lessee’s incremental borrowing rate or the interest rate
implicit in the lease if it is lower than the incremental rate and is known
to the lessee. The lessee’s depreciation depends on whether owner-
ship transfers to the lessee or if there is a bargain purchase option. If
one of these conditions is fulfilled, amortization would be over the eco-
nomic life of the asset. Otherwise, it would be depreciated over the
lease term. Because both the economic life of the asset and the lease term
are three years, the leased asset should be depreciated over this period.
The lessor should adopt the direct-financing lease method and replace
the asset cost of $95,000 with Lease Receivable of $95,000. (See
schedule below.) Interest would be recognized annually at a constant
rate relative to the unrecovered net investment.
Cost (fair value of leased asset) ............................................. $95,
Amount to be recovered by lessor through lease
payments .............................................................................. $95,
Three annual lease payments: $95,000 ÷ 2.53130* ............... $37,
*Present value of an ordinary annuity of 1 for 3 periods at 9%.
EXERCISE 21-5 (Continued)
(b) Schedule of Interest and Amortization
Rent Receipt/
Payment
Interest
Revenue/
Expense
Reduction of
Principal
Receivable/
Liability
**$95,000 X .09 = $8,
**rounding difference
LO: 2, 3, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, Measurement, AICPA PC: Communication
EXERCISE 21-6 (15–20 minutes)
(a) $35,013 X 5.7122* = $200,
*Present value of an annuity due of 1 for 8 periods at 11%.
(b) Lease Receivable ............................... 200,
Cost of Goods Sold ............................ 160,
Sales Revenue ............................ 200,
Inventory ..................................... 160,
Cash .................................................... 35,
Lease Receivable........................ 35,
Interest Receivable ............................ 18,
Interest Revenue ......................... 18,
[($200,001 – $35,013) X .11]
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
