a) distinguish between an operating lease and a finance lease based on the criteria for classifying a lease as a finance lease.
prepare the necessary journal entries to record an operating lease in
both the lessor's and the lessee's books.
prepare the necessary journal entries to record a finance lease in the
d) write and interpret the disclosure requirements for a finance lease and an operating lease in both the lessor's and lessee's books.
A lease is a contract between two parties – a lessor and a lessee. A
lease contract gives the
lessee rights to use the lessor’s property for a specified period of time in
return for periodic cash payments (rent) to the lessor.
There are two basic types of Leases, An Operating Lease and a Finance
Lease (a.k.a. Capital Lease)
An Operating Lease is one where the risks and rewards of owning the
asset remain with the lessor. Accordingly the asset is not treated as sold by
the lessor to the lessee, and remains on the lessor’s books.
A Finance Lease is where the risks and rewards of ownership are deemed
to have been passed from the lessor to the lessee. Accordingly the asset is
treated as being owned by the lessee.
To determine whether the risks and rewards of ownership have been
transferred to the lessee, at least one of the following four (4) criteria must
The Lease transfers title to the lessee
The Lease contains a Bargain Purchase Option (BPO)
The Lease term is 75% or more of the useful life of the Asset
The Present Value (PV) of the minimum lease payments (MLP) is 90% or
more of the Fair Market Value (FMV)
Pt.2 - BARGAIN PURCHASE OPTION (BPO) - This option allows the lessee to purchase the leased asset for an amount substantially lower than the expected FMV (see below) at the end of the Lease (e.g. $1).
Pt.3 - MINIMUM
LEASE PAYMENTS (MLP) – The payment that the lessee
is or can be required to make in connection with the leased asset, including:
Bargain Purchase option
3. Guaranteed Residual Value (GRV) – (Some lease contracts require lessees to guarantee the residual value to the lessor)
Pt. 4 - FAIR
MARKET VALUE (FMV) – The amount for which an asset could be exchanged between a knowledgeable and willing buyer and a knowledgeable and willing seller in an
arm’s length transaction.
PV of MLP is determined by discounting the MLP by using what is called the “
lessee’s incremental borrowing rate” (in terms of the lessee’s books) or
the “lessor’s implicit rate” (in terms of the lessor’s books). If both
the lessee’s incremental rate and the lessor’s implicit rate are the Same and
also if the residual value is guaranteed by the lessee, then
the PV of the MLP = FMV of the Asset. (This allows criteria #4 to be
previously mentioned, with the operating lease, the asset remains on the books
of the lessor. The lessor therefore depreciates the asset in the normal fashion.
The lessor will then receive periodic payments from the lessee representing
rental income to the lessor and rental expense to the lessee.
E.g. A 10-year operating lease is initiated on
January 1st, 1997. Payments are $100,000.00
per year, payable on December 31st each year.
the Books of The lessee In the Books of The lessor
Rental Expense $100,000.00
Rental Income $100,000.00
ENTRIES FOR FINANCE LEASE (In lessee's books)
The lessee records an asset and a liability with the PV of the MLP
Lease obligation xxxxxx
Each cash payment will consist of an interest portion and a principal
portion (which is used to reduce the lease
obligation). The lessee will use the Reducing
Method, otherwise called the Effective
Interest Method, to allocate each cash payment between interest and
Dr. Interest Expense
Dr. Lease obligation
(3) The lessee may also have to pay
other related asset expenses e.g. Insurance and/or Property Taxes.
Dr. Insurance/Property Taxes
The lessee will depreciate the asset over
The Lease term (if criteria 3 or 4 were met)
Or B. The Useful life (if criteria 1 or 2 were met
Cr. Accumulated depreciation
When the Lease terminates, the balance in the lease obligation account
should equal the bargain purchase option or the expected residual value. To
clear the lease related accounts from the lessee’s books (when there is no
If there were a BPO, then the entry to clear
the amounts, and therefore effectively exercise the option would be:
1 (Finance Lease in lessee’s Books)
A 4-year lease is initiated on 1/1/99 for equipment with an expected
useful life of 7 years. The equipment reverts back to the lessor upon
Four payments are due to the lessor in the amount of $50,000 per year
beginning 31/12/99. An additional sum of $1,000.00 is to be paid annually by the
lessee for insurance.
The lessee guarantees a $20,000.00 residual value on 31/12/2002 to the
lessor. The asset should be depreciated down to this expected residual value.
The lessee’s incremental borrowing rate is 20% (same as the lessor’s
= 2.58873 ;
4) = 0.48225
all the journal entries that are needed to record this lease in the lessee’s
books over the life of the Lease.
A 3-year lease is initiated on 1/1/98 for equipment with an expected
useful life of 5 years.
Three (3) annual payments of $70,000 each are due to the lessor
The lessee can exercise a bargain purchase option on 31/12/2000 for
$10,000. The expected residual value at 31/12/2000 is $1,000.00
The lessee’s incremental borrowing rate is 10%. (lessor’s implicit
rate is unknown)
= 2.48685 ;
(PVIF 10%,3) = 0.75131
: Show all the journal entries that are needed to record this
lease in the lessee’s books over the life of the Lease.
is the term for a transaction where the owner of property sells the property and
then immediately leases it or part of it back from the new owner. This is done
so that the original owner can still have use of the asset while generating a
major cash inflow.
however, that there is not a physical transfer of property. It is also important
to note that there are two separate and distinct economic transactions. First,
there is a sale of property and second, there is a lease agreement for the same
property in which the seller is now the lessee and the buyer is now the lessor.
for Leases are governed by the some following standards:
Statement of Financial Accounting Standard (SFAS)13 - USA
Statement of Standard Accounting Practice (SSAP) 21- ENGLISH
International Accounting Standard (IAS) 17 - Leases -
One of the main reasons for introducing a standard on leases was that
a number of Jamaican companies were treating finance leases as
operating leases and consequently expensing the entire lease payments
(i.e. both interest and principal) thereby reducing profit.
extract of the disclosure requirements of IAS 17 Leases (as they relate to lessees)
is presented below:
The amount of assets which are the subject of finance leases. Liabilities
related to these assets (shown separately from other liabilities) with the
current portions differentiated from the long-term portions.
Commitments for minimum lease payments under finance leases and under
non-cancellable operating leases with a term of more than one year shown in
summary form giving the amount and periods in which the payments will become
 The entries in the lessor's books are considered to be outside the scope of this course
 Paragraphs 57 and 58.
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