Capital/Finance Lease Accounting Example (Lessee)

 

FAS 13/IAS 17 Methodology

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Capital Example: Copier Lease
 
Let's take as an example a copier lease. The copier costs $3000 to purchase new; the lessor is willing to lease it to you for 3 years at a price of $115 per month, paid at the beginning of each month. Of that, $16 is identified as the cost of maintenance. If you borrowed money for three years, you would have to pay 8.5% interest. If you bought the copier, you would normally depreciate it over 5 years. There is an option to buy the copier at the end of the lease for $500, which is estimated to be its fair market value at that time.
 

First, we check the four capital vs. operating tests. There is no ownership transfer as part of the lease agreement, so criterion #1 is not met. The purchase option is not a "bargain" as defined by FAS 13, so criterion #2 is not met. The lease term of 3 years is less than 75% of the economic life of 5 years, so criterion #3 is not met.

 

Determining the present value of the rents takes a few more steps. First, we eliminate the maintenance cost; that is considered an "executory cost," and excluded from this calculation. Thus, the net rent is $99 per month. At your incremental borrowing rate of 8.5%, the present value of the rent is $3,158.35, which is more than 90% of the fair value of the asset. Thus, criterion #4 is met and the lease is capital.

 
A lease cannot be capitalized at a higher value than the fair market value, so an interest rate must be calculated which will cause the present value of the rents at that rate to be equal to the fair market value of the asset. For this lease, the needed interest rate is 12.26%.
 
The first month, you set up an asset and an obligation, make the first rental payment, then accrue interest and depreciation:
 
 
Sample capital lease journal entries, first month:
 
Account Debit Credit
 Gross asset

3,000.00

 
     Current obligation  
902.25
     Long term obligation  
2,097.75
 (Initial booking)    
 Current obligation
99.00
 
 Executory expense
16.00
 
     Cash  
115.00
 (Monthly rent payment)    
 Long term obligation
77.58
 
     Current obligation  
77.58
 (Obligation transfer, long term to current)    
 Interest expense
29.63
 
     Accrued interest  
29.63
 (Interest accrual for first month)    
 Depreciation expense
83.33
 
     Accumulated depreciation  
83.33
 (Depreciation accrual for first month)    
 
Note: The first rental payment, since it is made on the first day of the lease, goes entirely into obligation reduction. In following months, the interest accrued during the month is paid off by the rental payment, with the excess of rent over accrued interest going to obligation reduction. (In certain leases with scheduled rent increases, the rent paid may be less than the accrued interest. This results in an increase to the outstanding obligation, known as negative principal amortization.)
 
For this lease, the journal entries for month #2's rent payment would be:
 
 Current obligation
69.37
 
 Accrued interest
29.63
 
 Executory expense
16.00
 
     Cash  
115.00
 (Month #2 rent payment)    

 

Each month, the rent payment is booked in the manner shown above, depreciation and interest are accrued and expensed, and obligation is reclassified from long-term to current. When the lease expires (or if it is terminated before its scheduled expiration date), the asset and obligation are removed from the books, with a gain or loss recognized if the net asset and remaining obligation are unequal. This is almost always the case if the lease is early terminated. It may be the case with a normal expiration, most frequently when the lease conveys ownership or has a bargain purchase option, since the lease is then depreciated over its economic life, which is typically longer than the lease term, leaving an unamortized asset at expiration.

Note: You also need to disclose your future rent commitments, as well as the portion of future rent that is considered nonlease components and interest. At the end of the first year, for example, you have two years of $115 per month rent remaining.

 

So as of the end of year 1, your disclosure would be:

The following is a schedule by years of minimum future rentals on noncancelable capital leases as of December 31, 20X7:

 Year ending December 31,
 
     20X8: 1,380
     20X9: 1,380
 Total minimum payments required: 2,760
     Less executory costs: 384
 Net minimum lease payments: 2,376
     Less amount representing interest: 278

 Present value of net minimum lease payments:

2,098

 

 

 

 

 

 

 

 

 

 

 

Note: This description applies to the rules set out in FAS 13 for U.S. accounting.

Follow this link for the differences in the rules set out by the IASB for international accounting according to IAS 17 under IFRS (International Financial Reporting Standards).

See other tab for ASC 842/IFRS 16 finance lease accounting.

 

To enter this lease in the trial version of EZLease, follow these steps:

  • Enter a Begin Date (such as January 1 of the current year)
  • Double-click on the Lease Term; in the box that appears, enter 36 (or enter an end date that makes the lease term 36 months exactly, which will be one day earlier in the year than the begin date, such as December 31 if the lease starts on January 1)
  • Set the Classification According To to FAS 13 (or IAS 17, if you have set EZLease to IFRS accounting).
  • Leave Classification "To be classified" and Capital Rate blank, so EZLease can determine it
  • If not already displayed, click on the Main data tab
  • On the first line of the Rent Steps grid, enter Gross Rent of 115
  • Enter Executory cost of 16
  • Enter Economic Life of 60
  • Click on the Inception tab
  • Enter Incremental Borrowing Rate of 8.5
  • Enter Fair Value of Building/Equipment of 3000
  • Click Save. The classification is updated to Capital, and the Capital Rate is filled in.
 
See also our examples of operating lease accounting for FAS 13/IAS 17 and for ASC 842/IFRS 16.

 

 

Also test out our Asset Retirement Obligations reporting in the trial version of either EZLease or EZ ARO

 

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ASC 842/IFRS 16 Methodology

Get complete finance and operating lease accounting with EZLease.

 

Finance Example: Copier Lease, ASC 842/IFRS 16 methodology:
 
Let's take as an example a copier lease. The copier costs $6000 to purchase new; the lessor is willing to lease it to you for 3 years at a price of $230 per month, paid at the beginning of each month. Of that, $32 is identified as the cost of maintenance. If you borrowed money for three years, you would have to pay 8.5% interest. If you bought the copier, you would normally depreciate it over 5 years. There is an option to buy the copier at the end of the lease for $1000, which is estimated to be its fair market value at that time. You have no initial direct costs; you don't know what, if any, initial direct costs the lessor has.
 

ASC 842 only: First, we check the five capital vs. operating tests. There is no ownership transfer as part of the lease agreement, so criterion #1 is not met. Exercise of the purchase option is not reasonably certain, so criterion #2 is not met. The lease term of 3 years is less than 75% of the economic life of 5 years, so criterion #3 is not met. (We are following the guidance in ASC 842-10-55-2 that says "one reasonable approach" to the lease term and present value tests is the 75% and 90% thresholds of FAS 13.)

IFRS 16 only: If a lease is for an asset with a value, when new, of approximately US$5,000 or less, and there is no ownership transfer (express or reasonably certain of exercise based on a purchase option), you may exclude the lease from capitalization and treat it similarly to an IAS 17 operating lease.

 

Determining the present value of the rents takes a few more steps. First, we eliminate the maintenance cost; that is considered a "nonlease component," and excluded from this calculation. Thus, the net rent is $198 per month. At your incremental borrowing rate of 8.5%, the present value of the rent is $6,316.69, which is more than 90% of the fair value of the asset. Thus, criterion #4 is met and the lease is finance. (The "specialized asset" test is not met, but is not necessary.)

 
Since you don't know the lessor's initial direct costs, you cannot determine the implicit interest rate in the lease. Therefore, the discount rate for the lease is your incremental borrowing rate of 8.5%. Note that this results in an initial right-of-use asset and liability greater than the fair value of the leased asset; this is correct accounting under ASC 842/IFRS 16 (and is different from FAS 13/IAS 17). (Note that if you know the lessor's initial direct costs are zero, the implicit interest rate, using the $1000 purchase option price as the unguaranteed residual, would be 19.631%, which would then be the discount rate for the lease.)
 
The first month, you set up a right-of-use asset and a liability, make the first rental payment, then accrue interest and depreciation:
 
 
Sample finance lease journal entries, first month:
 
Account Debit Credit
 Right-of-use asset

6,316.69

 
     Current liability  
1,960.80
     Long term liability  
4,355.89
 (Initial booking)    
 Current liability
198.00
 
  Nonlease component expense
32.00
 
     Cash  
230.00
 (Monthly rent payment)    
 Long term liability
167.14
 
     Current liability  
167.14
 (Liability reclassification, long term to current)    
 Interest expense
43.35
 
     Accrued interest  
43.35
 (Interest accrual for first month)    
 Depreciation expense
175.46
 
     Accumulated depreciation  
175.46
 (Depreciation accrual for first month)    
 
Note: The first rental payment, since it is made on the first day of the lease, goes entirely into liability payment. The ASC 842/IFRS 16 standards actually call for setting up a different asset and liability, with the rent payment recognized as part of the initial setup of the lease, but the transactions above illustrate more clearly the activity involved. In following months, the interest accrued during the month is paid off by the rental payment, with the excess of rent over accrued interest going to principal (liability) reduction. (In certain leases with scheduled rent increases, the rent paid may be less than the accrued interest. This results in an increase to the outstanding liability, known as negative principal amortization.)
 
For this lease, the journal entries for month #2's rent payment would be:
 
 Current liability
154.65
 
 Accrued interest
43.35
 
 Nonlease component expense
32.00
 
     Cash  
230.00
 (Month #2 rent payment)    

 

Each month, the rent payment is booked in the manner shown above, depreciation and interest are accrued and expensed, and liability is reclassified from long-term to current. When the lease expires (or if it is terminated before its scheduled expiration date), the asset and liability are removed from the books, with a gain or loss recognized if the net asset and remaining liability are unequal. This is almost always the case if the lease is early terminated. It may be the case with a normal expiration, most frequently when the lease conveys ownership or has a bargain purchase option, since the lease is then depreciated over its economic life, which is typically longer than the lease term, leaving an unamortized asset at expiration.

Note: You also need to disclose your future rent commitments, as well as the portion of future rent that is considered nonlease components and interest. At the end of the first year, for example, you have two years of $230 per month rent remaining.

 

So as of the end of year 1, your disclosure would be:

The following is a schedule by years of minimum future payments on noncancelable finance leases as of December 31, 20X7:

 Year ending December 31,
 
     20X8: 2,376
     20X9: 2,376
 Total lease payments required: 4,752
     Less amount representing interest: 396

 Present value of net minimum lease payments:

4,356

 

 

 

 

 

 

 

 

(ASC 842 and IFRS 16 do not require disclosure of future nonlease component payments.)

 

Note: This description applies to the rules set out in ASC 842 for U.S. accounting and IFRS 16 for international accounting.

See other tab for a FAS 13/IAS 17 version.

 

To enter this lease in the trial version of EZLease, follow these steps:

  • Enter a Begin Date (such as January 1 of the current year; this should be on or after the new standard transition date, set in System Options, New Standard tab)
  • Double-click on the Base Term; in the box that appears, enter 36 (or enter an end date that makes the lease term 36 months exactly, which will be one day earlier in the year than the begin date, such as December 31 if the lease starts on January 1)
  • Set the Classification According To to ASC 842 (or IFRS 16, if you have set EZLease to IFRS accounting).
  • Leave Classification "To be classified" and Capital Rate blank, so EZLease can determine it
  • If not already displayed, click on the Main data tab
  • On the first line of the Rent Steps grid, enter Gross Rent of 230
  • Enter Comp #1 (nonlease component #1) of 32
  • Enter Economic Life of 60
  • Click on the Inception tab
  • Enter Incremental Borrowing Rate of 8.5
  • Enter Fair Value of Building/Equipment of 6000
  • Click Save. The classification is updated to Finance, and the Discount Rate is filled in as 8.5.
 
See also our examples of operating lease accounting for FAS 13/IAS 17 and for ASC 842/IFRS 16.

 

 

Also test out our Asset Retirement Obligations reporting in the trial version of either EZLease or EZ ARO

 

Download Here