A lease is in form a rental of property, but maybe in substance, the acquisition of an asset, and the related obligation. This has financial accounting and reporting implications for both the lessor and the lessee.
The lessee should, if certain criteria are met, treat the lease as a capital lease and record an asset and related obligation equal to the present value of the minimum lease payments. If the criteria are not met, the lease should be treated as an operating lease.
The lessor should treat the lease as a sales-type lease if a profit or loss is involved and certain criteria are met. Sales-type leases are usually confined to manufacturers and dealer lessors, but not necessarily. If the lease is not a sales-type lease, but the incidence of ownership has been relinquished by the lessor due to the terms of the lease (in effect, a capital lease for the lessee), the lease should be classified as a direct financing lease.
Leases that meet the criteria of leveraged leases are not to be treated as direct financing leases. Operating leases are those who do not qualify for treatment in the other categories, and lease rentals received are credited to income.
Classification of Leases
Lessees can classify leases as:
1. Capital leases
The lessee will record an asset and an obligation equal to the present value of the minimum lease payments during the lease term, not to exceed the fair value, if at least one of the following criteria are met:
- The lease transfers ownership of the property at the end of the lease term.
- The lease contains a bargain purchase option.
- The lease term is 75% or more of the economic life of the property.
- The present value of the minimum lease payments(excluding reimbursements for other costs) is 90% or more of the fair value of the leased property.
In general, minimum lease payments are those required to be made in connection with the lease, except that executory costs such as insurance, maintenance, and taxes should be excluded. Charge executory costs to lease expense. Minimum lease payments are increased by any guarantee of the residual value at the expiration of the lease term; any payment required because of failure to renew or extend the lease. Minimum lease payments are increased by escalator provisions in the lease agreement or commitment, where property is being constructed or acquired for later use.
If the lease meets criterion (A) or (B), the asset should be amortized consistent with the lessee's normal depreciation policy for owned assets. If not, and the lease falls under either criterion (C) or (D) as a capital lease, normal depreciation policies should be followed except that the period of amortization should be the lease term. The lease should be amortized to its expected value, if any, at the end of the lease term.
2. Operating leases
Rent is charged to expense over the lease term on a straight-line basis in case of an operating lease. If prepayments are made under the lease terms, such prepayments will be classified as assets and amortized over the life of the lease.
Lessors can classify leases as:
1. Sales-type leases
These are leases which give rise to a profit or loss at the inception of the lease; i.e., the fair value of the leased property is greater or less than the lessor cost or carrying value, if different, and:
- The lease meets the capital lease criteria for lessees, and
- Both of the following conditions are met:
- Collectibility of the lease payments is reasonably predictable, and
- There are no important uncertainties that exist as to unreimbursable costs yet to be incurred by the lessor.
2. Direct financing leases
These are leases that meet all the above criteria of sales-type leases except that no manufacturer or dealer profit or loss is involved, and the lease is not a leveraged lease. Otherwise, the lease should be classified as an operating lease. In direct financing leases, the cost of the leased property and the fair value are the same at the inception of the lease. A renewal or extension of an existing sales-type or direct financing lease which otherwise qualifies as a sales-type lease shall be classified as a direct financing lease unless the renewal or extension occurs within the last few months of the existing lease in which case it shall be classified as a sales-type lease.
3. Leveraged leases
4. Operating leases
Rent is reported as income as it becomes receivable over the operating [ lease term on a straight-line basis. Initial direct costs should be deferred and allocated over the lease term in proportion to the recognition of rental income, but may be expensed as incurred if the effect is not material. The leased property should be included with or near property, plant and equipment in the balance sheet.
The above article is about Accounting for leases tested on the FAR CPA Exam. Hope this helps. If you have any queries, feel free to comment in the section below. Happy Learning!
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