Accounting for Lease

Accounting for Lease

How to classify and account for lease for lessor

To record a lease, first we need to determine what type of lease it is. There are basically three types of leases for lessor: operating, direct-financing and sales-type lease. The Financial Accounting Standards Board (FASB) set two groups of criteria, which are shown below, to distinguish different leases. For the lessor, If the lease meets any one of the four Group I criteria and both of the Group II criteria, and it does not give rise to manufacturer's or dealer's profit (or loss) (which means the fair value and the book value of the leased asset are the same), the lease shall be treated as a direct-financing lease. (ASC 840-10-25-43)

Group I (ASC 840-10-25-1)

1. The lessor transfers ownership of the asset to the lessee at the end of the lease term.

2. The lease contains a bargain purchase option (BPO). This is an option that allows the lessee, upon termination of the lease, to purchase the leased asset at a price significantly lower than the expected fair value of the asset.

3. The term of the lease is equal to 75% or more of the estimated economic life of the asset.

4. The present value of the minimum lease payments is equal to or greater than 90% of the fair value of leased asset. The minimum lease payments include the minimum rental payments, the guaranteed residual value, and the bargain purchase option.

Group II (ASC 840-10-25-42)

1. Collectability of the payments required from the lessee is reasonably predictable.

2. No important uncertainties about the amount of unreimbursable costs yet to be incurred by the lessor under the lease. (lessor's performance is substantially complete or future costs are reasonably predictable).

For lease involving both land and building, as in our case, FASB requires that : If a lease does not meet either No.1 or No.2 of Group I criteria and the fair value of the land is less than 25 percent of the total fair value of the leased property at lease inception, (in our case, $28,000 / $120,000 < 25%) the lessor shall consider the land and the building as a single unit for purposes of applying No.3 and No.4 of Group I criteria, and the estimated economic life of the building shall be considered as the estimated economic life of the unit (ASC 840-10-25-63). If either No.3 or No.4 of Group I criteria is met, the lessor shall account for the lease as a single unit as a direct financing lease. (ASC 840-10-25-64)

Briggs meets the Group I No.4 criterion as well as other criteria to classify and account for the lease as a direct-financing lease. It calculates and records the lease transaction as follows:

Group I No.4 criterion: PV minimum payment >= 90% fair value

$110,880/$120,000=92.4%

PVA=AxIF(8%, 6yr)= $24,000x4.62=$110,880

20x1 Journal Entries for Briggs (Lessor) (in US$)

Gross Investment1 158,476

Unearned Interest2 38,476

Land & Building 120,000

Cash 24,000

Gross Investment 24,000

Unearned Interest3 9,600

Interest Revenue 9,600

Depreciation Exp.4 9,200

Accumulate Dep. 9,200

Account Balances on Dec. 31, 20x2

Building 92,000 Gross Investment6 110,476

Less: Accumulated Dep.5 18,400 Unearned Interest7 20,428

Net 73,600 Net Investment 90,048

Determine the lease type for lessee

There are two types of leases for lessee: operating and capital lease. We use only Group I criteria which is the same as what the lessor uses to determine the lease type. When the lessee meets any of one the four Group I criteria, the lease will be recorded as a capital lease, otherwise, the lease is an operating lease. Similarly, we need to consider the fact that the lease involves both land and building, however, since the fair value of the land ($30,000) is 25 percent of the total fair value of the leased property ($120,000) at lease inception, the lessee shall consider the land and the building separately for purposes of applying the No.3 and No.4 of Group I criteria (ASC 840-10-25-66). To do so, we need first determine the allocation between the land and the building. The annual minimum lease payments applicable to the land element is determined by applying the lessee's incremental borrowing rate to the fair value of the land; the remaining minimum lease payments shall be attributed to the building element. If the building element of the lease meets neither of the two criteria, both the building element and the land element shall be accounted for by the lessee as a single operating lease (ASC 840-10-25-38). Rex shall record the transaction as an operating lease because the lease failed all four criteria.

Group I No.4 criterion: PV minimum payment >= 90% fair value

Annual minimum lease payment applicable to the land: $30,000 x 10% = $3,000

Annual minimum lease payment applicable to the building: $24,000 - $3,000 = $21,000

PVA=AxIF(10%, 6yr)= $21,000x4.36=$91,560

$91,560/$120,000=76.3%

20x1 Journal Entries for Rex Chainbelt (Lessee)

Rental Expense 24,000

Cash 24,000

Situation 1: Sublease

According to FASB, if the nature of a sublease is such that the original lessee is not relieved of the primary obligation under the original operating lease, the original lessee (as sublessor) shall account for both the original lease and the new lease as operating leases. (ASC 840-20-25-14)

Since this lease has a scheduled rent increase, which