Key Things to Know

Intermediate Accounting 2

Key Things To Know


Lease: contractual agreement between the lessee and the lessor that grants the lessee the right to control the identified asset

Lessee: has the right to use the asset
Lessor: provides the asset to the lessee

Under GAAP:
The lessee reports an asset and liability on the balance sheet for all leases that are for longer than one year

Lessee lease types:

Operating Lease:
temporary use

Finance Lease:
in-substance the agreement is a financed purchase/sale of an asset

Lessor lease types:

Operating Lease:
temporary use

Direct Financing:
third party guarantees the residual value

Sales-type Lease:
without a sales profit
with a sales profit

A lease is a Finance (lessee) or Sales-type (lessor) if any one of the following:

1. Agreement specifies that ownership of the asset (title) transfers to the lessee

2. Agreement contains a purchase option the lessee is reasonably certain to exercise (“bargain purchase option”)

3. Lease term is for “major part” of the remaining economic life of the asset
(reasonable to conclude that 75% or more is a major part)

4. Present value of minimum lease payments > “substantially all” of the fair value
of the asset (reasonable to assume 90% or more is substantially all)

5. The asset is specialized and the lessor does not expect to have an alternative use
(only the lessee can obtain the economic rewards of ownership)

The lease term includes:

Noncancelable period
+ Renewal options if reasonably certain
+ Renewal options the lessor controls
– Time after the date of a purchase option
= Total Lease Term

Lease payments include:

Fixed Payments include:

Periodic payments
+ Reasonably certain bargain purchase option
+ Reasonably certain termination penalty
+ In-substance fixed payments
+ Variable payments based on an index (i.e. inflation adjustment)
+ Excess of guaranteed residual value over expected residual value
= Total Lease Payments

Determine the Present Value of Minimum Lease Payments

Annual Payment
x  PV of Annuity Due for n periods at x%
=  Present value of minimum lease payments

Determine the Lease Payment:

FMV of asset (current cash price)
–   Present value of RV or BPO
=  Payments cover
/   PV factor from annuity due table
=  Payment

The “Amortization Schedule” (see below) computes interest for each period

Interest decreases as the balance owed decreases

The interest rate is typically stated in the lease
(if not, use the lessee’s borrowing rate)

Example: On January 1, 20X1, ABC Co. leases an asset to XYZ, Inc. The FMV of the asset is $438,721. XYZ, Inc. agreed to pay $100,000 annually beginning on January 1, 20X1 at the inception of the lease and then on December 31, 20X1 through 20X4 (5-year lease). The estimated useful life of the asset is 6 years. The interest rate in the lease is 7%. XYZ, Inc. will return the asset to ABC Co. at the end of the lease.

*       No interest expense until time passes
**     Last outstanding balance (previous row) x interest % ($338,721 x 7%)
***   Payment less interest ($100,000 – $23,710)
**** Previous period outstanding balance less decrease ($338,721 – $76,209)

Journal Entries: Finance or Sales-type Lease

Lease Receivable/Payable: Record PV of Minimum lease payment

Reporting operating leases on the financial statements:

Report “Lease Revenue” or “Lease Expense” at the amount of the lease payment
(Straight-line basis: same amount each period)

Lessee does not report interest expense and amortization expense separately

Short-term Lease:

Lessee can choose not to record the asset and liability if:

Twelve months or less, and
Lessee has no option to extend the lease, or

If there is an option to extend the lease, it is not reasonable the lessee would exercise an option to extend the lease

Residual Values (RV):

Show the residual value amount as a final payment on the amortization schedule
The asset returned is the payment and the lessee does not pay cash

Record interest and payable/receivable separately

Guaranteed RV
added to lease receivable
added to sales revenue

Excess of Guaranteed RV over expected RV
added to right of use asset and lease liability

Unguaranteed RV
added to lease receivable
PV of RV is subtracted from sales revenue and cost of goods sold

Lessee: Useful Life for Amortization

Life of Lease: When the lessee will return the asset at the end of the lease
Life of Asset: When lessee will own the asset when the lease is over

Bargain Purchase Option
Assume the lease ends when the lessee has the option to purchase the asset
Show the bargain purchase amount as a final payment on the amortization schedule

Record the payment with the same debits and credits as a periodic payment
(interest and amount owed recorded separately)

Remeasurement after Modifications to the Assumed Lease Terms
Compute the present value of the remaining lease payments using the lessee borrowing rate

Compare the new PV to the current payable/receivable balance

Increase or decrease the payable/receivable balance


Maintenance, insurance, property taxes

Record separate from the lease payment:


Initial Direct Costs (legal fees, commissions, document fees)

Lessee: Add to the right of use asset

Lessor with selling profit: expense
Lessor with no selling profit: defer and expense over the lease term

Operating Lease: defer and expense over the lease term


Sale-Leaseback Arrangements:

Lessee sells an asset to the lessor and immediately leases it back from the lessor

Sale-Leaseback Approach: (sale meets the revenue recognition requirements)

Record the sale like selling any other long-term assets

Recognize the gain or loss on the sale in the period of the sale

Account for the lease the same as if the lessee did not sell the asset first

Financing Arrangement
(does not meet the revenue recognition requirements)

Record the sale as a loan to the lessor

The asset remains on the lessee’s books

Account for the cash exchange as debt – record loan repayments


Lessor Direct Financing Lease:

The present value of the lessee’s lease payments is less than substantially all of the fair value of the asset

A third party is paid to guarantee the fair value of the asset at the end of the lease

Therefore, the lease payments in total are substantially all of the fair value of the asset

Lessor is in substance providing financing to the lessee
Lessor – accounts for the lease similar to a sales-type with no profit

If the lessor sells the asset at a profit (rare), the lessor defers the profit until the
end of the lease