Definition of lease
The lessor (property owner) and lessee (user) sign a lease.
The lessor grants the lessee the right to use the property for a set time in exchange for financial payments.
Lease accounting has long been controversial.
The main issue is whether capital leases are actually installment purchases and how to account for them.
Types of Leases
Lessees have two sorts of leases: operating and capital.
Each lease form requires a particular accounting approach, thus the distinction is crucial.
Thus, capital vs operating leases have significant effects on the balance sheet and income statement.
FASB Statement No. 13, Accounting for Leases, classifies a lease as a capital lease if it fits one or more of the following criteria:
At the end of the lease, the lessee owns the property.
The lease allows the lessee to buy the asset at a discount.
Lease duration is 75% or more of property’s anticipated economic life.
Present value of minimum lease payments is 90% or more of the lessor’s fair market value of the property at lease start.
Thus, capital leases are considered equipment or property purchases. Purchases are financed through leases rather than loans.
As we will see, these leases require the lessee to record the asset and liability on their books as if they had purchased it.
A lease without the preceding characteristics is an operating lease. The lessor retains control and ownership of the property, which reverts at the end of the lease.
Lessees just need to record lease payments as they are made to account for this form of lease.
Both lease kinds are not possibilities for the same transaction.
If the lease terms meet any of the four conditions, it’s a capital lease.
Take Scully Corporation’s lease with Porter Company on January 2, 2019, to demonstrate lease accounting.
Scully Corporation leases equipment for five $13,850 annual payments.
Year-end payments are made. For simplicity, we assume annual payments even though most are made monthly.
This data will show the accounting techniques for operating and capital leases to compare and contrast.
This is simply an illustration because the lease must be a capital or operating lease.
Accounting for Operating Leases
In the event that this contract is an operational lease, Scully Corporation does not record the signing on 2 January 2019.
Currently, the lease is only an agreement that neither party has fulfilled.
Scully Corporation enters the following on 31 December for the next five years:
Scully Corporation Operating Lease Journal Entry
The full lease payment is an expenditure. The lessor depreciates the equipment.
Scully Corporation spends $69,350 on the 5-year lease ($13,870 x 5 years).
Accounting for Capital Leases
Scully Corporation records equipment as an asset and lease payments as a liability under a capital lease.
We assume a 12% interest rate for this lease to record the asset and obligation at the current value of the lease payments.
Scully Corporation then pays principle and interest and depreciates the equipment annually.
The lessor removes the rented equipment and registers a receivable for the lease payments’ present value.
At 12% interest, $13,870 in lease payments are worth $50,000. Discounting the 5-year $13,870 annuity at 12% yields this.
The lease begins on 2 January 2019, and Scully Corporation makes the following entry based on this data:
The non-current Leased Equipment Under Capital Lease account is usually listed under property, plant, and equipment.
Obligation Under Capital Lease is a present and long-term liability.
Interest is calculated using 12% of the lease commitment at the start of each year.
Thus, in 2019, interest is $6,000 (12% of $50,000) and in 2020, $5,056 (12% of $42,130).
Principal is the difference between the annual lease payment and interest. The first payment entry is:
For leased equipment depreciation, Scully Corporation must submit one additional entry each year.
The leased equipment is depreciated straight-line over five years with no salvage value.
Operating vs. Capital Leases
The table below compares Scully Corporation’s operational and capital leases.
Both situations incur $69,350 in financial outflows over five years.
However, each strategy produces a different 5-year expense trend.
Capital leasing results in greater annual expenses than operating lease in the first 3 years.
Lower annual net income occurs in these years. In the final two years of the lease, this pattern flips.
The lease accounting controversy centers on these relationships.
Before Statement 13, corporations had a lot of leeway in classifying leases as operating or capital.
Most corporations thought it was best to designate most leases as operating.
Some obvious lease-financed purchases were operating leases when they should have been capital leases.
Operating leases have no balance sheet responsibility for lease payments.
The lease arrangement does not influence the lessee’s current ratio or working capital.
Balance sheet liabilities must be regarded current liabilities for the following year’s payment.
All Leased Equipment Under Capital Lease balances are non-current assets.
Off-balance sheet financing is when the lessee made an installment purchase without having to record the asset or liabilities.
Off-balance sheet financing lowers a company’s debt-to-equity ratio and boosts ROI.
Operating leases have lower yearly costs than capital leases in the first few years.
Some managers prefer classifying leases as operating leases due to these concerns and the risk that creditors will react negatively if leases are capitalized on the balance sheet.
FASB Statement No. 13 remedied several evident cases where capital leases were accounted for as operational leases.
Statement 13’s four requirements record installment purchase leases as capital leases.
The right asset, liability, interest expense, and depreciation are recorded.
Current accounting regulations require extensive lease term and agreement footnote disclosure.