Accounting For Leases In The United States Article Index for
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Accounting For Leases In The United States
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ACCOUNTING FOR LEASES BY THE LESSEE

A Lease is defined as a Contractual agreement between a lessor and lessee that gives the lessee the right to use specific Property , either owned by or in the possession of the lessor, for a specified period of time in return for stipulated, and generally periodic, Cash payment.

The (IASB) announced the commencement of a joint project to comprehensively reconsider lease accounting, with the intention to release a new standard in 2009. {Link without Title}

The basic criteria for capitalization of a lease by lessee are as follows:
  • The lessor transfers Ownership of the Asset to the lessee.

  • A Bargain purchase option is given to the lessee. 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 Market Value of the asset. (Intermediate acct. 11th ed, Kieso Weygandt Warfield)

  • The life of the lease is greater than 75% of the Economic life of the asset.

  • The present value of the minimum lease payments (MLP) is equal to or greater than 90% of the fair market value of leased property. To understand and apply this criterion, you need familiarize yourself with what is included in the minimum lease payments and how the present value is calculated. The minimum lease payments include the minimum rental payments minus any executory cost, the guaranteed Residual Value , the bargain purchase option, and any penalty for failure to renew or extend the lease. The amount calculated is then discounted using the lessee’s incremental borrowing rate. However, if the lessee knows the implicit rate used by the lessor and the rate is less than the lessee’s rate, the lessee should use the lessor’s rate to discount the minimum lease payment.

    • If any of these criteria for capitalization are met, the lease should be capitalized and reported on the financial statements by the lessee. If none of the criteria is met, the lease is considered operating and is generally reported (aside from the rent expense) only in the footnotes to the financial statements. For a more in depth explanation, see the accounting textbook ''Intermediate Accounting'', 11th ed, Kieso Weygandt Warfield.



LESSEE ACCOUNTING

Under an operating lease, the lessee records rent expense ( Debit ) over the lease term, usually on a straight-line basis and a credit to either cash or rent payable.

Under a capital lease, the lessee does not record rent as an expense. Instead, the rent is reclassified as interest and obligation payments, similarly to a mortgage (with the interest calculated each rental period on the outstanding obligation balance). At the same time, the asset is depreciated. If the lease has an ownership transfer or bargain purchase option, the depreciable life is the asset's economic life; otherwise, the depreciable life is the lease term. Over the life of the lease, the interest and depreciation combined will be equal to the rent payments.

Other lessee financial accounting issues:

  • Leasehold Improvements: Improvements made by the lessee. These are permanently affixed to the property, and revert back to the lessor at the termination of the lease. The value of the leasehold improvements should be capitalized and depreciated over the lesser of the lease life or the leasehold improvements life.


  • Lease Bonus: Prepayment for future expenses. Classified as an asset; amortized using the straight-line method over the life of the lease.


  • Rent Kicker, or Percentage Rent: Common in retail store leases. This is a premium rent payment that the lessor requires and is treated as a period expense. For example, it may be stated in the Contract that if sales are over $1,000,000, any excess over this amount will have 2% taken out as a rent kicker.



LESSOR ACCOUNTING


Under an operating lease, the lessor records rent revenue ( Credit ) and a corresponding debit to either cash/rent receivable. The asset remains on the lessor's books as an owned asset, and the lessor records depreciation expense over the life of the asset.

Under a capital lease, the lessor credits owned assets and debits a lease receivable account for the present value of the rents (an asset, which is broken out between current and long-term, the latter being the present value of rents due more than 12 months in the future). With each payment, cash is debited, the receivable is credited, and unearned (interest) income is credited.

Other Issues

Usually, when a lease is entered into, a Security deposit is required. There are two types of security deposits:

  • Nonrefundable security deposits: Deferred by the lessor as unearned revenue; Capitalized by the lessee as a prepaid rent expense until the lessor considers the deposit earned.


  • Refundable security deposits: Treated as a receivable by the lessee; Treated as a liability by the lessor until the deposit is refunded to the lessee.