Accounting for Leases

Accounting standards require lessees to recognize a right of use asset and associated lease liability for almost all leases. Lessors, on the other hand, are required to classify leases into operating leases and finance leases and recognize finance lease receivable only in respect of finance leases.

Lease accounting has underdone significant changes due to introduction of the new lease accounting standards (IFRS 16 and ASC 842). Earlier, both lessees and lessors were required to classify their leases based on whether they transfer significantly all risks and rewards incidental to ownership. Under the new accounting standards, whether a party recognizes an asset and/or liability arising from a lease depends on whether the party is a lessee or a lessor and if lessor, whether the lease is a finance lease.

Accounting by lessees

The new accounting standards require a lessee to capitalize almost all leases on its balance sheet. Leases result in recognition of both an asset (often referred to as a right of use asset) and a lease liability in the books of the lessee at the commencement date.

The lease liability is measured at the present value of lease payments which mainly comprise of all fixed payments and variable payments which are linked to some index or rate. The right of use asset is measured at cost.

Example

PMA, Inc. is a rail company which has leased out diesel generators from GP, Ltd. to provide backup to the transportation system during power outages. The lease has 5-year term in which PMA must make $500,000 payment to GP at the end of each year. Journalize the transaction at the commencement date of the lease and the first payment made by PMA in the books of the PMA and GP if PV of lease payments is $1,996,355 and rate of interest implicit in the lease is 8%.

Since the lease liability equals the present value of lease payments, and there are no initial direct costs, etc., the lessee shall record the transaction as follows

Right of use asset$1,996,355
Lease liability$1,996,355

After initial recognition, a lessee increases the lease liability by recognize interest expense on the lease liability and decreases it by the payments it made during the periods. A lessee typically prepares a lease amortization schedule.

In the example above, at the time of first annual payment, the lessee records the following journal entry:

Lease liability$460,000
Interest expense ($500,000 × 8%)$40,000
Cash$500,000

Subsequently, the lessee accounts for the ROU assets just like an owned/acquired asset. It recognizes depreciation expense and impairment losses, if any, on the ROU asset. in accordance with its policy for fixed assets.

Capitalization of a lease results in front-loading of expense, i.e. higher expense is recognized in earlier periods.

Accounting by lessors

A lessor is required to first determine whether a lessee is an operating lease or a finance lease. Only finance leases are required to be capitalized on balance sheet.

The lessor shall record the start of a lease by creating a lease receivable at its net investment in lease, which is equal to the lease payments discounted at the rate of interest implicit in the lease.

A lease is either:

  • a finance lease (also called capital lease in the US GAAP) in which the risks and rewards inherent in the asset are transferred to the lessee.
  • an operating lease in which the risks and rewards inherent in the asset are not transferred to the lessee.

Other classifications include: sales-type lease and direct financing lease.

Substance-over-form principle is applied to determine whether risks and rewards have transferred or not; which means that transfer of legal ownership is not very relevant in deciding whether a lease is an operating lease or a finance lease.

Since a finance lease involves transfer of risk and rewards, the leased asset is recorded in the books of the lessee together with a corresponding lease liability. The leased asset is recorded at the present value of minimum lease payments (or fair value if it is lower). The present value of lease payments is determined using the rate of interest implicit in the lease (or the lessee’s incremental rate of return if the interest rate implicit in the lease is not available).

Journal entries in case of a finance lease

Following the example above, if we determine that the lease is a finance lease, the lessor shall pass the following journal entry at the start of the lease contract:

Lease receivable$1,996,355
Asset$1,996,355

At the time of first payment, lessor shall record receipt of cash, reduction in lease receivable and recognition of finance income:

Cash$500,000
Lease receivable ($500,000-40,000)$460,000
Finance income ($500,000×8%)$40,000

The reduction in lease receivable reduces the principal balance in lease receivable (also called net investment in lease) to $1,536,355, which shall reduce the next year finance income.

Journal entries in case of an operating lease

If a lessor determines a contract to contain only an operating lease, it is not required to recognize any asset or liability. The lease income is recognized on a basis reflecting the use of the asset.

If the contract in the example discussed above is determined not to contain a finance lease, no journal entry shall be made the start of the lease contract. The lessor continues to recognize and depreciate the leased asset on its balance sheet.

During the first year, the lessor shall recognize receipt of lease rental as follows:

Cash$500,000
Lease rental income$500,000

by Obaidullah Jan, ACA, CFA and last modified on

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