Chapter 6

Accounting for leases

6.1. The Leasing Environment
Aristotle once said, “Wealth does not lie in ownership but in the use of things”! Clearly, many
U.S. companies have decided that Aristotle is right, as they have become heavily involved in
leasing assets rather than owning them. What types of assets are being leased? As the opening
story indicated, any type of equipment can be leased, such as railcars, helicopters, bulldozers,
barges, CT scanners, computers, and so on. The largest group of leased equipment involves
information technology equipment, followed by assets in the transportation area (trucks, aircraft,
rail), and then construction and agriculture.
Leases can be broadly classified as operating leases and capital leases.
If the lease agreement transfers a “material ownership interest” from the lessor to the lessee, it is
a capital lease. If not, it is an operating lease.

Who are the players?

A lease is a contractual agreement between a lessor and a lessee that gives the lessee the right to
use specific property, owned by the lessor, for a specified period of time. In return for the use of
the property, the lessee makes rental payments over the lease term to the lessor. Who are the
lessors that own this property? They generally fall into one of three categories:
1. Banks: They have low-cost funds, which give them the advantage of being able to purchase
assets at less cost than their competitors.
2. Captive leasing companies: Captive leasing companies are subsidiaries whose primary
business is to perform leasing operations for the parent company. Captive leasing companies
have the point-of-sale advantage in finding leasing customers.
3. Independents: Independents are the final category of lessors. Independents have not done
well over the last few years. Their market share has dropped fairly dramatically as banks and
captive leasing companies have become more aggressive in the lease-financing area.
Independents do not have point-of-sale access, nor do they have a low cost of funds
advantage. What they are often good at is developing innovative contracts for lessees. In
addition, they are starting to act as captive finance companies for some companies that do not
have a leasing subsidiary.
Largest group of leased equipment involves:
 Information technology equipment  Construction
 Transportation (trucks, aircraft, rail)  Agriculture
6.2 Overview of Ethiopian lease business law
Under commercial code of 1960, from article 195 up to 205, states about lease issues.
 Contract of Lease, Lease Registration, and Exception’s in Contract Lease
Under article 195, 196 and 198 states about contract of lease, its registration, and exception’s in
contract lease respectively.
Art. 195. - Publication of the contract of lease.
(1) A contract of lease shall not affect the rights of third parties unless it is in writing and
it is published, on the application of either party, in the official commercial gazette
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 and in a newspaper empowered to publish legal notices circulating at the place where
the head office of the business is situate.
(2) Notices published under sub-art. (1) Shall show the:
a. names and addresses of the lessor and lessee;
b. date and nature of the contract;
c. objects and address of the business;
d. Period of time for which the contract ill entered into.
Art. 196. - Registration: The owner of the business let out for hire shall cause his name to be
struck off and the lessee shall cause his name to be entered in the commercial register in
accordance with the provisions of commercial register.
Art. 198. - Particulars on business papers: The contract of lease may be cancelled where the
lessee fails to add the word "lessee" on all his business papers.
 Lessor’s liability, lessee’s duty and lease’s guarantee
Article 197,199 and 200 presents lessor’s liability, lessee’s duty and lease’s guarantee issues.
Art. 197. - Liability of the lessor: Until the provisions of Art. 195 and 196 have been complied
with and within one month from such formalities having been completed, the owner shall be
jointly and severally liable with the lessee for any debt incurred by the lessee in operating the
business.
Art. 199. - Duties of lessee: The contract of lease may be cancelled where the lessee fails to pay
the agreed rent on the agreed day or does not operate the business with the care due by a good
trader and in accordance with the objects of such business.
Art. 200
(1) – Guarantee: In addition to the rent, the contract of .lease may provide that the lessee
shall produce sureties to guarantee the fulfillment of his obligations towards the lessor or
third parties.
(2) Notwithstanding any provision to the contrary, the sureties shall be fully returned to the
lessee upon the termination of the lease, where the lessee has fulfilled his obligations and
no application is made by the creditors within the period of time specified in Art. 202 (3).
 Lessee’s personal duty and other issues related to lease
Art. 201. - Lessee personally to carry out his duties.
The lessee may not assign the contract of lease without the written consent of the lessor,
as a contract of lease is made on the basis of the personal qualifications of the lessee.
Art. 202. - Termination of contract of loose to be published.
(1) Where the contract of lease terminates, notices to this effect shall be published as
provided in Art. 195 (1).
(2) Notices published under sub-art (1) shall show the:
(a) Names and addresses of the lessor and lessee;
(b) Objects and address of the business;
(c) Date of termination of the contract;
(d) Amount of the guarantee under Art. 200, if any.
(3) The owner of the business shall be liable to third parties where the sureties under Art.
200 are returned to the lessee earlier than one month from the publication of the last
notice.
Art. 203. - Debts of lessee shall become due.
Any claim which a creditor may have against the lessee shall become due on the
termination of the contract of lease.
Art. 204. - Prohibition of trade by the lessor.

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 (1) During the currency of the contract of lease, the owner of the business may not
compete with the lessee by creating or acquiring a business having similar objects.
(2) Where the owner disregards the prohibition provided in sub art. (1), he shall be liable
for damages and his business may be closed.
Art. 205. - Prohibition of trade by the lessee.
(1) The parties may agree that, upon the termination of the contract of lease, the lessee
shall not compete with the owner of the business by carrying on a trade similar to the
trade carried on by the owner.
(2) Any such prohibition shall not be effective for more than five years.
Advantages of Leasing
The growth in leasing indicates that it often has some genuine advantages over owning property,
such as:
1. 100% financing at fixed rates. Leases are often signed without requiring any money down
from the lessee. This helps the lessee conserve scarce cash—an especially desirable feature
for new and developing companies. In addition, lease payments often remain fixed which
protects the lessee against inflation and increases in the cost of money. The following
comment explains why companies choose a lease instead of a conventional loan: “Our local
bank finally came up to 80 percent of the purchase price but wouldn’t go any higher, and
they wanted a floating interest rate. We just couldn’t afford the down payment, and we
needed to lock in a final payment rate we knew we could live with.”
2. Protection against obsolescence. Leasing equipment reduces risk of obsolescence to the
lessee and in many cases passes the risk of residual value to the lessor. For example, Merck
(a pharmaceutical maker) leases computers. Under the lease agreement. Merck may turn in
an old computer for a new model at any time, canceling the old lease and writing a new one.
The lessor adds the cost of the new lease to the balance due on the old lease, less the old
computer’s trade-in value. As one treasurer remarked, “Our instinct is to purchase.” But if a
new computer is likely to come along in a short time, “then leasing is just a heck of a lot
more convenient than purchasing. “Naturally, the lessor also protects itself by requiring the
lessee to pay higher rental payments or provide additional payments if the lessee does not
maintain the asset.
3. Flexibility. Lease agreements may contain less restrictive provisions than other debt
agreements. Innovative lessors can tailor a lease agreement to the lessee’s special needs. For
instance; the duration of the lease – the lease term – may be anything from a short period of
time to the entire expected economic life of the asset. The rental payments maybe level from
year to year, or they may increase or decrease in amount. The payment amount may be
predetermined or may vary with sales, the prime interest rate, the Consumer Price Index, or
some other factor. In most cases, the rent is set to enable the lessor to recover the cost of the
asset plus a fair return over the life of the lease.
4. Less costly financing. Some companies find leasing cheaper than other forms of financing.
For example, start-up companies in depressed industries or companies in low tax brackets
may lease to claim tax benefits that they might otherwise lose. Depreciation deductions offer
no benefit to companies that have little if any taxable income. Through leasing, the leasing

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 companies or financial institutions use these tax benefits. They can then pass some of these
tax benefits back to the user of the asset in the form of lower rental payments.
5. Tax advantages. In some cases, companies can “have their cake and eat it too” with tax
advantages that leases offer. That is, for financial reporting purposes, companies do not
report an asset or a liability for the lease arrangement. For tax purposes, however, companies
can capitalize and depreciate the leased asset. As a result, a company takes deductions earlier
rather than later and also reduces its taxes. A common vehicle for this type of transaction is a
“synthetic lease ”arrangement.
6. Off-balance-sheet financing. Certain leases do not add debt on a balance sheet or affect
financial ratios. In fact, they may add to borrowing capacity. Such off-balance-sheet
financing is critical to some companies.
Conceptual Nature of a Lease
Capitalize a lease that transfers substantially all of the benefits and risks of property
ownership, provided the lease is non-cancelable. Non-cancelable means that the company can
cancel the lease contract only upon the outcome of some remote contingency, or that the
cancellation provisions and penalties of the contract are so costly to Delta that cancellation
probably will not occur. Those leases that do not transfer substantially all the benefits and risks
of ownership are operating leases. Companies should not capitalize operating leases. Instead,
companies should account for them as rental payments and receipts.

The various views on capitalization of leases are as follows.

1. Do not capitalize any leased assets. This view considers capitalization inappropriate because
the company does not own the property. Furthermore, a lease is an “executory” contract
requiring continuing performance by both parties. Because companies do not currently
capitalize other executory contracts (such as purchase commitments and employment
contracts), they should not capitalize leases either.
2. Capitalize leases that are similar to installment purchases. This view holds that companies
should report transactions in accordance with their economic substance. Therefore, if
companies capitalize installment purchases, they should also capitalize leases that have
similar characteristics. For example, a company may make the same payments over a 10-year
period for either a lease or an installment purchase. Lessees make rental payments, whereas
owners make mortgage payments.
3. Capitalize all long-term leases. This approach requires only the long-term right to use the
property in order to capitalize. This property-rights approach capitalizes all long-term leases.
4. Capitalize firm leases where the penalty for nonperformance is substantial. A final
approach advocates capitalizing only “firm” (non-cancelable) contractual rights and
obligations. “Firm” means that it is unlikely to avoid performance under the lease without a
severe penalty.
 Underlying Concepts: The issue of how to report leases is the classic case of substance
versus form. Although legal title does not technically pass in lease transactions, the
benefits from the use of the property do transfer.

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 6.3 ACCOUNTING BY THE LESSEE
There are two methods of recording leases by the lessee: Capitalization and Operating methods.
1. Capitalization Method (Lessee)
If the lessee capitalizes a lease, the lessee records an asset and a liability generally equal to the
present value of the rental payments.
 Records depreciation on the leased asset.
 Treats the lease payments as consisting of interest and principal.
Illustration: Journal Entries for Capitalized Lease

Having capitalized the asset, Air France records depreciation on the leased asset. Both the Lessee
and Lessor treat the lease rental payments as consisting of interest and principal.
In order to record a lease as a capital lease, the lease must be non-cancelable. Further, it must
meet one or more of the four criteria listed in Illustration below:

Capitalization Criteria (Lessee) – the following are capitalization criteria’s for a finance
lease, the IASB has identified four criteria.
 The lease transfers ownership of the property to the lessee.
 The lease contains a bargain-purchase option.
 The lease term is equal to more or major part of the estimated economic life of the leased
property.
 The present value of the minimum lease payments (excluding executory costs) equals or
exceeds substantial all of the fair value of the leased property.

- Leases that do not meet any of the four criteria are accounted for as operating leases.
Illustration: Diagram of Lessee’s Criteria for Lease Classification

Lease Agreement

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Capitalization Criteria:
Transfer of Ownership Test: If the lease transfers ownership of the asset to the lessee, it is a
finance lease.
Bargain-Purchase Option Test: At the inception of the lease, the difference between the option
price and the expected fair market value must be large enough to make exercise of the option
reasonably assured.
Economic Life Test
 Lease term is generally considered to be the fixed, non-cancelable term of the lease.
 Bargain-renewal option can extend this period.
 At the inception of the lease, the difference between the renewal rental and the expected
fair rental must be great enough to make exercise of the option to renew reasonably
assured.
Illustration: Carrefour (FRA) leases Lenovo (CHN) PCs for twoyears at a rental of €100 per
month per computer and subsequently can lease them for €10 per month per computer for
another two years. The lease clearly offers a bargain-renewal option; the lease term is considered
to be four years.
Recovery of Investment Test
1. Minimum Lease Payments:
 Minimum rental payments
 Guaranteed residual value
 Penalty for failure to renew or extend the lease
 Bargain-purchase option
2. Executory Costs:
 Insurance
 Maintenance Exclude from PV of Minimum Lease Payment
 Taxes Calculation
3. Discount Rate:
 Lessee computes the present value of the minimum lease payments using the
implicit interest rate.
 In the event it is impracticable to determine the implicit rate, the lessee should use
its incremental borrowing rate.
Asset and Liability Accounted for Differently
Asset and Liability Recorded at the lower of:
1. present value of the minimum lease payments (excluding executory costs) or
2. fair market value of the leased asset at the inception of the lease.
Depreciation Period
 If lease transfers ownership, depreciate asset over the economic life of the asset.
 If lease does not transfer ownership, depreciate over the term of the lease.
Effective-Interest Method
 Used to allocate each lease payment between principal and interest
Depreciation Concept

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  Depreciation and the discharge of the obligation are independent accounting processes.
Illustration: CNH Capital (NLD) (a subsidiary of CNH Global) and Ivanhoe Mines Ltd. (CAN)
sign a lease agreement dated January 1, 2015, that calls for CNH to lease a front-end loader to
Ivanhoe beginning January 1, 2015. The terms and provisions of the lease agreement and other
pertinent data are as follows.
• The term of the lease is five years. The lease agreement is non-cancelable, requiring
equal rental payments of $25,981.62 at the beginning of each year (annuity-due basis).
• The loader has a fair value at the inception of the lease of $100,000, an estimated
economic life of five years, and no residual value.
• Ivanhoe pays all of the executory costs directly to third parties except for the property
taxes of $2,000 per year, which is included as part of its annual payments to CNH.
• The lease contains no renewal options. The loader reverts to CNH at the termination of
the lease.
• Ivanhoe’s incremental borrowing rate is 11 percent per year.
• Ivanhoe depreciates similar equipment that it owns on a straight-line basis.
• CNH sets the annual rental to earn a rate of return on its investment of 10 percent per
year; Ivanhoe knows this fact.
Required: What type of lease is this? Explain. Prepare lease amortization table for the lessee.

Computation of Capitalized Lease Payments

Payment $25,981.62
Property taxes (executory cost) - 2,000.00
Minimum lease payment 23,981.62
Present value factor (i=10%,n=5) x 4.16986
PV of minimum lease payments $100,000.00
Ivanhoe uses CNH’s implicit interest rate of 10 percent instead of its incremental borrowing rate
of 11 percent because (1) it is lower and (2) it knows about it.
Ivanhoe records the finance lease on its books on January 1, 2015, as:
Leased Equipment 100,000.00
Lease Liability 100,000.00
Ivanhoe records the first lease payment on January 1, 2015, as follows.
Property Tax Expense ………. 2,000.00
Lease Liability ……………… 23,981.62
Cash ………………………………….. 25,981.62
Lease Amortization Schedule for Lessee – Annuity-Due Basis

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Prepare the entry to record accrued interest at December 31, 2015.
Interest Expense 7,601.84
Interest Payable 7,601.84
Prepare the required journal entry on December 31, 2015, to record depreciation for the year
using the straight-line method ($100,000 ÷ 5 years).
Depreciation Expense 20,000
Accumulated Depreciation – Leased Equipment 20,000
The liabilities section as it relates to lease transactions at December 31, 2015.
Reporting Current and Non-Current Lease Liabilities

Ivanhoe records the lease payment of January 1, 2016, as follows.

Property Tax Expense 2,000.00
Interest Payable 7,601.84
Lease Liability 16,379.78
Cash 25,981.62

2. Operating Method (Lessee)

The lessee assigns rent to the periods benefiting from the use of the asset and ignores, in the
accounting, any commitments to make future payments.
Illustration: Assume Ivanhoe accounts for the lease as an operating lease. Ivanhoe records the
payment on January 1, 2015, as follows.
Rent Expense ……………. 25,981.62
Cash …………………………….25,981.62
Differences using finance lease instead of an operating lease.
1. Increase in amount of reported debt (both short-term and long-term).
2. Increase in amount of total assets (specifically long-lived assets).
3. Lower income early in the life of the lease, therefore lower retained earnings.

Illustration: Comparison of Charges to Operations—Capital vs. Operating Leases

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 6.4 ACCOUNTING BY THE LESSOR
Three important benefits of lease are available to the lessor:
1. Interest revenue: Leasing is a form of financing. Banks, captives, and independent
leasing companies find leasing attractive because it provides competitive interest
margins.
2. Tax incentives: In many cases, companies that lease cannot use the tax benefit of the
asset, but leasing allows them to transfer such tax benefits to another party (the lessor) in
return for a lower rental rate on the leased asset.
3. Residual value profits: Another advantage to the lessor is the return of the property at
the end of the lease term. Residual values can produce very large profits.
Economics of Leasing
A lessor determines the amount of the rental, basing it on the rate of return – the implicit rate –
needed to justify leasing the asset. If a residual value is involved (whether guaranteed or not), the
company would not have to recover as much from the lease payments.
Classification of Leases by the Lessor
a. Operating leases.
b. Finance leases
 Direct-financing leases
 Sales-type leases

Illustration: Diagram of Lessor’s Criteria for Lease Classification

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Direct-Financing Method (Lessor)
In substance the financing of an asset purchase by the lessee.
Lessor records as:
 A lease receivable instead of a leased asset.
 Receivable is the present value of the minimum lease payments plus the present
value of the unguaranteed residual value.
Illustration:
Using the data from the preceding CNH/Ivanhoe example we illustrate the accounting treatment
for a direct-financing lease. We repeat here the information relevant to CNH in accounting for
this lease transaction.
1. The term of the lease is five years beginning January 1, 2015, non-cancelable, and
requires equal rental payments of $25,981.62 at the beginning of each year. Payments
include $2,000 of executory costs (property taxes).
2. The equipment (front-end loader) has a cost of $100,000 to CNH, a fair value at the
inception of the lease of $100,000, an estimated economic life of five years, and no
residual value.
3. CNH incurred no initial direct costs in negotiating and closing the lease transaction.
The lease meets the criteria for classification as a direct-financing lease for two reasons:
1. the lease term equals the equipment’s estimated economic life, and
2. the present value of the minimum lease payments equals the equipment's fair value.
It is not a sales-type lease because there is no difference between the fair value ($100,000) of
the loader and CNH’s cost ($100,000).
ILLUSTRATION: Computation of Lease Receivable

CNH records the lease of the asset and the resulting receivable on January 1, 2014 (the inception
of the lease), as follows.
Lease Receivable ………….. 100,000
Equipment …………………………….. 100,000

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Companies often report the lease receivable in the statement of financial position as “Net
investment in finance leases.
ILLUSTRATION: Lease Amortization Schedule for Lessor – Annuity-Due Basis

On January 1, 2014, CNH records receipt of the first year’s lease payment as follows.
Cash 25,981.62
Lease Receivable 23,981.62
Property Tax Expense/Property Taxes Payable 2,000.00
On December 31, 2014, CNH recognizes the interest revenue earned during the first year
through the following entry.
Interest Receivable 7,601.84
Interest Revenue 7,601.84
At December 31, 2014, CNH reports the lease receivable in its statement of financial
position among current assets or non-current assets, or both. It classifies the portion due
within one year or the operating cycle, whichever is longer, as a current asset, and the rest
with non-current assets.
ILLUSTRATION: Reporting Lease Transactions by Lessor

The following entry records the receipt of the second year's lease payment on January 1, 2015.
Cash ………………………………………… 25,981.62
Lease Receivable ………………………………………….. 16,379.78
Interest Receivable ………………………………………… 7,601.84
Property Tax Expense/Property Taxes Payable …………… 2,000.00
The following entry records the recognition of interest earned on December 31, 2016.
Interest Receivable ………. 5,963.86
Interest Revenue ………………5,963.86
Operating Method (Lessor)
 Records each rental receipt as rental revenue.
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  Depreciates leased asset in the normal manner.
Assuming that the direct-financing lease illustrated for CNH does not qualify as a finance lease,
CNH accounts for it as an operating lease and records the cash rental receipt as follows.
Cash 25,981.62
Rental Revenue 25,981.62
Depreciation is recorded as follows: ($100,000 ÷ 5 years = $20,000)
Depreciation Expense 20,000
Accumulated Depreciation 20,000
6.5 SPECIAL ACCOUNTING PROBLEMS
This subtopic will help you identify special features of lease arrangements that cause unique
accounting problems.

1. Residual values
Meaning of Residual Value - Estimated fair value of the leased asset at the end of the lease
term.
Guaranteed versus Unguaranteed – A guaranteed residual value is when the lessee agrees to
make up any deficiency below a stated amount that the lessor realizes in residual value at the end
of the lease term.
Lease Payments - Lessor may adjust lease payments because of the increased certainty of
recovery of a guaranteed residual value.
Lessee Accounting for Residual Value - The minimum lease payment includes a guaranteed
residual value but excludes an unguaranteed residual value.
Lease Payments
Illustration: Assume the same data as in the CNH/Ivanhoe illustrations except that CNH
estimates a residual value of $5,000 at the end of the five-year lease term. In addition, CNH
assumes a 10 percent return on investment (ROI), whether the residual value is guaranteed or
unguaranteed. The terms and provisions of the lease agreement and other pertinent data are as
follows.
• The term of the lease is five years. The lease agreement is non-cancelable, requiring
equal rental payments of $25,981.62 at the beginning of each year (annuity-due basis).
• The loader has a fair value at the inception of the lease of $100,000, an estimated
economic life of five years.
• Ivanhoe pays all of the executory costs directly to third parties except for the property
taxes of $2,000 per year, which is included as part of its annual payments to CNH.
• The lease contains no renewal options. The loader reverts to CNH at the termination of
the lease.
• Ivanhoe’s incremental borrowing rate is 11 percent per year.
• Ivanhoe depreciates similar equipment that it owns on a straight-line basis.
• CNH sets the annual rental to earn a rate of return on its investment of 10 percent per
year; Ivanhoe knows this fact.
CNH assumes a 10 percent return on investment (ROI), whether the residual value is guaranteed
or unguaranteed. CNH would compute the amount of the lease payments as follows.

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ILLUSTRATION: Lessor’s Computation of Lease Payments

Le
ase Accounting for Residual Value
Guaranteed Residual Value (Lessee Accounting): An additional lease payment that the lessee
will pay in property or cash, or both, at the end of the lease term.
Illustration: Computation of Lessee’s Capitalized Amount – Guaranteed Residual Value

Illustration: Lease Amortization Schedule for Lessee – Guaranteed Residual Value (lessee)

At the end of the lease term, before the lessee transfers the asset to CNH, the lease asset and
liability accounts have the following balances.
Illustration: Account Balances on Lessee’s Books at End of Lease Term—Guaranteed Residual
Value

Assume that Ivanhoe depreciated the leased asset down to its residual value of $5,000 but that
the fair market value of the residual value at December 31, 2019, was $3,000. Ivanhoe would
make the following journal entry.

Loss on Disposal of Equipment 2,000.00

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 Interest Expense (or Interest Payable) 454.76
Lease Liability 4,545.24
Accumulated Depreciation—Leased Equipment 95,000.00
Leased Equipment 100,000.00
Cash 2,000.00
Unguaranteed Residual Value (Lessee Accounting)
Assume the same facts as those above except that the $5,000 residual value is unguaranteed
instead of guaranteed. CNH will recover the same amount through lease rentals—that is,
$96,895.40. Ivanhoe would capitalize the amount as follows:
Illustration: Computation of Lessee’s Capitalized Amount—Unguaranteed Residual Value

I
llustration: Lease Amortization Schedule for Lessee—Unguaranteed Residual Value

At the end of the lease term, before Ivanhoe transfers the asset to CNH, the lease asset and
liability accounts have the following balances.
Illustration: Account Balances on Lessee’s Books at End of Lease Term—Unguaranteed
Residual Value

Lessee Entries Involving Residual Values

Illustration: Comparative Entries for Guaranteed and Unguaranteed Residual Values, Lessee
Company

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Lessor Accounting for Residual Value: The lessor works on the assumption that it will
realize the residual value at the end of the lease term whether guaranteed or unguaranteed.
Illustration: Assume a direct-financing lease with a residual value (either guaranteed or
unguaranteed) of $5,000. CNH determines the payments as follows.

Illustration: Lease Amortization Schedule, for Lessor – Guaranteed or Unguaranteed Residual

Value

CNH would make the following entry for this direct-financing lease on 1/1/14.
Lease Receivable 100,000.00
Equipment 100,000.00

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CNH would make the following entry for this direct-financing lease on 1/1/14.
Cash 25,237.09
Lease Receivable 23,237.09
Property Tax Expense/Property Taxes Payable 2,000.00
CNH would make the following entry for this direct-financing lease on 12/31/14.
Interest Receivable 7,676.29
Interest Revenue 7,676.29

2. Sales-Type Leases (Lessor)

 Primary difference between a direct-financing lease and a sales-type lease is the
manufacturer’s or dealer’s gross profit (or loss).
 Lessor records the sale price of the asset, the cost of goods sold and related inventory
reduction, and the lease receivable.
 There is a difference in accounting for guaranteed and unguaranteed residual values.

Direct-Financing versus Sales-Type Leases

LEASE RECEIVABLE (also referred to as NET INVESTMENT). The present value of the
minimum lease payments plus the present value of any unguaranteed residual value. The lease
receivable therefore includes the present value of the residual value, whether guaranteed or
[Link] PRICE OF THE ASSET. The present value of the minimum lease payments.
COST OF GOODS SOLD. The cost of the asset to the lessor, less the present value of any
unguaranteed residual value.

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Illustration: To illustrate a sales-type lease with a guaranteed residual value and with an
unguaranteed residual value, assume the same facts as in the preceding direct-financing lease
situation. The estimated residual value is $5,000 (the present value of which is $3,104.60), and
the leased equipment has an $85,000 cost to the dealer, CNH. Assume that the fair market value
of the residual value is $3,000 at the end of the lease term.
Illustration: Computation of Lease Amounts by CNH Financial—Sales-Type Lease

Comparative Entries

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3. Bargain Purchase Option (Lessee)
 Lessee must increase the present value of the minimum lease payments by the
present value of the option.
 Only difference between the accounting treatment for a bargain-purchase option
and a guaranteed residual value of identical amounts is in the computation of the
annual depreciation.

4. Initial Direct Costs (Lessor)

Accounting for initial direct costs:
 Operating leases, the lessor should defer initial direct costs.
 Sales-type leases, the lessor expense the initial direct costs.
 Direct-financing lease, the lessor adds initial direct costs to the net investment.

5. Current versus Noncurrent

Both the annuity-due and the ordinary-annuity situations report the reduction of principal for the
next period as a current liability/current asset.

ILLUSTRATION: Lease Amortization Schedule – Ordinary – Annuity Basis

The current portion of the lease liability/receivable as of December 31, 2015, would be
$18,017.70.
6. Disclosure Requirements for Leases
For lessees:
 A general description of material leasing arrangements.

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  Reconciliation between the total of future minimum lease payments at the end of the
reporting period and their present value.
 The total of future minimum lease payments at the end of the reporting period, and their
present value for periods (1) not later than one year, (2) later than one year and not later
than five years, and (3) later than five years.
For lessors:
 A general description of material leasing arrangements.
 A reconciliation between the gross investment in the lease at the end of the reporting
period, and the present value of minimum lease payments receivable at the end of the
reporting period.
 Unearned finance income.
 The gross investment in the lease and the present value of minimum lease payments
receivable at the end of the reporting period for periods (1) not later than one year, (2)
later than one year and not later than five years, and (3) later than five years.

6.5 Unresolved Lease Accounting Problems

To avoid leased asset capitalization, companies design, write, and interpret lease agreements
to prevent satisfying any of the four finance lease criteria. The real challenge lies in
disqualifying the lease as a finance lease to the lessee, while having the same lease qualify as
a finance (sales or financing) lease to the lessor. Unlike lessees, lessors try to avoid having
lease arrangements classified as operating leases.

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