INTERMEDIATE

ACCOUNTING

Leases

DERRICK BONYUET
Clinical Assistant Professor of Accounting, The University of Texas at Austin
Agenda
• Overview
• Lease Classification
• Finance Lease
• Operating Lease
• Problems
Why Lease?
Operational, financial, and tax incentives often make leasing
an attractive alternative to purchasing.
These advantages are laid out below:
1. Leasing reduces the upfront cash needed to use an asset.
2. Lease payments often are lower than installment payments.
3. Leasing offers flexibility and a lower cost when disposing of the
asset.
4. Leasing might offer protection against the risk of declining asset
values.
5. Leasing might offer tax advantages.
LEASE CLASSIFICATIONS
For accounting purposes, we classify leases as follows:

Lessee Lessor

• Finance Lease • Sales-type lease

without selling profit
with selling profit
• Operating Lease • Operating Lease

Note: Short-term leases (12 months or less) are expensed

Lease Classification Criteria
A lease is considered a finance lease if it meets any of the following:
1.Transfer of ownership: the underlying asset transfers to the lessee at the end of the lease term.
2.Option to purchase: Lessee has the option to purchase the underlying asset and the lessee is
reasonably certain to exercise.
3.Majority of the economic life: The lease term is for the major part of the remaining economic
life of the underlying asset.
4.Present value of payments: The present value of the lease payments equals or exceeds
substantially all of the fair value of the underlying asset.
5.No alternative use: The underlying asset has a specialized nature that results in no alternative
use to the lessor at the end of the lease term.
Lease Classification 1: Finance vs. Operating
• Tech Co signs a ten-year noncancelable lease for a new
corporate headquarters in Austin Texas. The lessor is Longhorn
Capital. The terms of the lease are as follows:
1. The lease calls for ten annual payments of $825,000.
2. The leased asset has a fair value of $35,250,000.
3. The implicit rate in the lease is 10%.
4. The lease has no renewal option, and possession of the asset reverts to Longhorn
Capital, the lessor, at the end of the term.
5. The building has an expected economic life of 25 years.

Discussion groups: Does this qualify as a finance or operating lease?

Lease Classification 2: Finance vs. Operating
• Tech Co signs a ten-year noncancelable lease for a new, high-
power server. The lessor is Server Co. The terms of the lease
are as follows:
1. The lease calls for ten annual payments of $725,000.
2. The leased asset has a fair value of $22,250,000.
3. The implicit rate in the lease is 8%.
4. The lease has no renewal option, and possession of the asset reverts to Longhorn
Capital, the lessor, at the end of the term.
5. The sever has an expected economic life of 12 years.

Does this qualify as a finance or operating lease?

Lease Classification 3: Finance vs. Operating
• Farm Co signs a ten-year noncancelable lease for a tractor.
The lessor is Supply Co. The terms of the lease are as follows:
1. The lease calls for ten annual payments of $525,000.
2. The leased asset has a fair value of $4,000,000.
3. The implicit rate in the lease is 5%.
4. The lease has no renewal option, and possession of the asset reverts to Supply Co,
the lessor, at the end of the term.
5. The tractor has an expected economic life of 15 years.

Does this qualify as a finance or operating lease?

Lease Classification 4: Finance vs. Operating
• Farm Co signs a ten-year noncancelable lease for a tractor.
The lessor is Supply Co. The terms of the lease are as follows:
1. The lease calls for ten annual payments of $525,000.
2. The leased asset has a fair value of $6,000,000.
3. The implicit rate in the lease is 5%.
4. The lease has no renewal option. At the end of the term, Farm Co has an option to
purchase the tractor for $10,000.
5. The tractor has an expected economic life of 15 years.

Does this qualify as a finance or operating lease?

Comparing Operating and Finance Lease
Initial recognition and measurement
• Identical for operating and finance leases
• Record the lease asset and liability at present value
Dr. Right to Use Asset XX
Cr. Lease Liability XX

Example: A firm leases a building for 10 years for payments of $1,000. The present value of payments is $8,000
when discounted at a 4.28% rate. The firm applies capital lease accounting.

Initial Entry
Dr. ROU Asset 8,000
Cr. Lease Liability 8,000
Comparing Operating and Finance Lease
Lease liability amortization table & journal entries
• Identical amounts for operating and finance leases
• Different names for finance and operating leases
– If finance lease, expense is called “interest expense”
– If an operating lease, expense also called “interest expense”*

• Record the following

Year 1 Lease entryLease
Payment – Finance Year 1 Lease Payment – Operating Lease
Dr. Interest Exp (4.28%*8,000) 342 Dr. Int Exp (4.28%*8,000) 342
Dr. Lease Liability (plug) 658 Dr. Lease Liability (plug) 658
Cr. Cash (payment amt) 1,000 Cr. Cash (payment amt) 1,000
*Some textbooks label this as “lease expense”
Comparing Operating and Finance Lease
Step 3: Amortize the asset
• Differs based on finance vs operating lease criterion
– For finance leases, amortize the asset on a straight-line basis
– For operating leases, plug amortization expense so that total “lease expense” is equal to straight-line lease expense (i.e. payment
amount)

• Record the following entry

Year 1 Amortization – Finance Lease Year 1 Amortization – Operating Lease

Use straight line depreciation Remember, interest expense so far is 342
Lease expense should be 1,000
Dr. Amort Exp (8,000/10) 800 1,000-342 = 658
Cr. ROU Asset 800
Dr. Amort Exp (Plug) 658
Cr. ROU Asset 658
“…The initial recognition of operating leases on balance sheets could have led companies’ equity
valuations to shrink…before the rule…public companies used to disclose operating leases…”

“…shift(ing) more information from the footnotes to the balance sheet…could have a negative
impact on stock returns…ultimately make it easier for investors to use financial statements, but
they could hurt companies in the near term…”
“…effect on stock returns was especially noticeable for the retail industry…”

“…rule change also presents an opportunity for companies to improve their returns by using the
unearthed leasing data to optimize the financing process and make better decisions about internal
controls…”
“…an estimated $3.3 trillion in leases, currently buried in the footnotes of financial statements, are expected to find
their way onto corporate balance sheets…”

“…that will disturb corporate debt-to-earnings ratios, a metric lenders use to set loan covenants…the new
accounting method could trigger those covenants—and erode the borrowing power of some companies…”

“…finance chiefs are pressed with a choice: renegotiate loan terms, provide lenders with specialized financial
reports, or run the risk of having debts called by lenders…”
Exercise
On January 1, 2024, Time Publications leased printing equipment from
Printex. Printex purchased the equipment from Lenavo at a cost of
$479,079.
• The lease agreement specifies six annual payments of $100,000
beginning January 1, 2024, the beginning of the lease, and on each
December 31 from 2024 through 2028.
• The six-year lease term ending December 31, 2029, is equal to the
estimated useful life of the equipment.
• Printex routinely acquires equipment to lease to other firms.
• The interest rate in these financing arrangements is 10%.

Finance or operating lease?

Beginning of the Lease (Lessee)
Journal Entry – January 1 Debit Credit
Time Publications (Lessee)
Right-of-use asset
479,079
Lease payable
479,079
An asset and liability are recorded by the lessee at the present value of the
lease payments.

Printex (Lessor)
Lease receivable 479,079
Equipment 479,079
Notice that the lessor’s entries are the flip side or mirror image of the
lessee’s entries.

$100,000 x 4.79079* = $479,079

*Present value of an annuity due of $1: n = 6, i = 10%
Journal Entries for Lease Payments
First Lease Payment (January 1, 2024)

Time Publications (Lessee)

Lease Payable 100,000
Cash (lease payment) 100,000

Printex (Lessor)
Cash (lease payment) 100,000
Lease receivable 100,000
Journal Entries for Lease Payments
Second Lease Payment (December 31, 2024)
Time Publications (Lessee)
Interest expense (10% x [$479,079 – 100,000]) 37,908
Lease payable (difference) 62,092
Cash (lease payment) 100,000

Effective Rate Outstanding

Balance
Printex (Lessor)
Cash (lease payment) 100,000
Lease receivable (difference) 62,092
Interest revenue (10% x [$479,079 – 100,000])
37,908
Lease Amortization Schedule
Decrease in Outstanding
Payments Effective Interest Balance* Balance
(10% × Outstanding (Pmt. – Interest)
balance)
1/1/24 479,079
No interest yet;
1/1/24 100,000 no time has 100,000 379,079
passed.
12/31/24 100,000 .10 (379,079) = 37,908 62,092 316,987
12/31/25 100,000 .10 (316,987) = 31,699 68,301 248,686
12/31/26 100,000 .10 (248,686) = 24,869 75,131 173,555
12/31/27 100,000 .10 (173,555) = 17,355 82,345 90,910
12/31/28 100,000 .10 (90,910) = 9,090 90,910 0
600,000 120,921 Ɨ 479,079

*Payment in first column minus the interest in the second column

Ɨ Adjusted for rounding of other numbers in the schedule
Amortization of Right-of-Use Asset
December 31, 2024 and End of Next Five Years
Amortization expense 79,847 *
Right-of-use asset
79,847

*$479,079 / 6 years

The lessee incurs an expense as it uses the asset. This

is similar to the recording of depreciation expense
associated with purchased assets.
Class Exercise
Lamar Corporation entered into an arrangement, which qualifies as a capital lease, and calls for
annual lease payments of $26,269 over a six-year term (also the asset’s useful life). First payment
is due at the beginning of the lease. The interest rate is 5%. If Lamar’s fiscal year is the calendar
year, what would be:
a) The lease liability at the end of the first year
b) The amounts reported in its income statement for the first year (ignore taxes)
Operating Leases
• Doesn’t meet any of the criteria for a finance lease.
• Fundamental rights and responsibilities of ownership are retained by the lessor.
• Lessee merely uses the asset temporarily.
• A sale is not recorded by the lessor; the lessor records lease revenue on a
straight-line basis.
• Lessee records the right-of-use asset and lease payable at commencement based
on present value of lease payments.
• Lease payable is considered a non-debt liability.
Exercise
On January 1, 2024, Time Publications leased printing equipment from Printex.
• Printex purchased the equipment from Lenavo at a cost of $479,079.
• Time Publications’ borrowing rate for similar transactions is 10%.
• The lease agreement specifies four annual payments of $100,000 beginning
January 1, 2024, the beginning of the lease, and at each December 31 from
2024 through 2026.
• The useful life of the equipment is estimated to be six years.
• The present value of those four payments at a discount rate of 10% is
$348,685.
Finance or operating lease?

Operating lease as present value of the payments < 90% of fair value and
4yrs / 6yrs = 67% < 75%.
$100,000 x 3.48685* = $348,685
Lease payments Lessee’s cost
*Present value of an annuity due of $1: n = 4, i = 10%.
Operating Lease: Entries

Beginning of the Lease (January 1, 2024)

Time Publications (Lessee)
Right-of-use asset (PV of lease payments) 348,685
Lease payable (PV of lease payments) 348,685

Printex (Lessor)
[No entry to record a receivable or to derecognize asset]

Because the lessor does not take the asset off its books,
it must depreciate that asset (over its useful life).
Operating Lease: Interest and Amortization

First Lease Payment (January 1, 2024)

Time Publications (Lessee)
Lease payable 100,000
Cash (lease payment) 100,000

Printex (Lessor)
Cash (lease payment) 100,000
Deferred lease revenue (lease revenue in 2024) 15-25 100,000
Operating Lease: Interest and Amortization
Second Lease Payment (December 31, 2024)
Time Publications (Lessee)
Interest expense [10% × ($348,685 – 100,000)] 24,869
Lease payable (difference) 75,131
Cash (lease payment) 100,000

Printex (Lessor)
Deferred lease revenue (Jan 1. lease payment) 100,000
Lease revenue 100,000
Cash (second lease payment) 100,000
Deferred lease revenue (lease revenue in 2025) 100,000
Depreciation expense ($479,079 ÷ 6 years) 79,847
Accumulated depreciation 79,847
LEASE AMORTIZATION SCHEDULE

Decrease in Outstanding
Payments Effective Interest Balance Balance
(10% × Outstanding balance)
1/1/24 No interest; no time has 348,685
1/1/24 100,000 passed 100,000 248,685
12/31/24 100,000 0.10 (248,865) = 24,869 75,131 173,554
12/31/25 100,000 0.10 (173,554) = 17,355 82,645 90,909
12/31/26 100,000 0.10 (90,909) = 9,091 90,909 0
400,000 51,315 348,685
Operating Lease: Interest and Amortization
Interest $ 24,869
Amortization 75,131
Lease expense $100,000

Second Lease Payment (December 31, 2024)

Time Publications (Lessee)
Interest expense [10% × ($348,685 – 100,000)] 24,869
Lease payable (difference) 75,131
Cash (lease payment) 100,000
Amortization expense ($100,000 – $24,869) 75,131
Right-of-use asset
75,131
 Jan. 1, 2024 Dec. 31, 2024 Dec. 31, 2025

Time Publications (Lessee)

Right-of-use asset 348,685

Operating Lease payable 348,685

Interest expense 0 24,869 17,355

Lease— Lease payable 100,000 75,131 82,645

Determining Cash 100,000 100,000 100,000

Lease Expense Amortization expense 75,131 82,645

Right-of-use asset ________ 75,131 ________ 82,645

and Revenue Total lease expenses each year = $100,000 $100,000

Printex (Lessor)

[No entry to record receivable or to derecognize asset]

Cash 100,000 100,000 100,000

Deferred revenue 100,000 100,000 100,000

Deferred revenue 100,000 100,000

Lease revenue 100,000 100,000

Depreciation expense 79,847 79,847

Accumulated depreciation 79,847 79,847

 Dec. 31, 2026 Dec. 31, 2027
Time Publications (Lessee)
Right-of-use asset
Lease payable
Operating Interest expense 9,091 0

Lease— Lease payable 90,909 0

Cash 100,000 0
Determining Amortization expense 90,909 100,000
Lease Expense Right-of-use asset ________ 90,909 ________ 100,000

and Revenue Total lease expenses each year= $100,000 $100,000

Printex (Lessor)
(concluded)
[No entry to record receivable or to derecognize
asset]
Cash 100,000
Deferred revenue 100,000
Deferred revenue 100,000 100,000
Lease revenue 100,000 100,000
Depreciation expense 79,847 79,847
Accumulated depreciation 79,847 79,847
Comparison of Lessee’s Expense Recognition
Finance Lease Operating Lease
Financing Approach Straight-Line Approach
Interest Amortization Total Interest Amortization Total
Expense Expense Expense Expense Expense Expense
2024 24,869 87,171 112,040 24,869 75,131 100,000
2025 17,355 87,171 104,526 17,355 82,645 100,000
2026 9,091 87,171 96,262 9,091 90,909 100,000
2027 0 87,171 87,171 0 100,000 100,000
51,315 348,685* 400,000* 51,315 348,685 400,000
*Adjusted for rounding of other numbers in the schedule.

In an operating lease, it’s the total lease

expense, not the amortization component, that's
a straight-line amount.
Class Exercise
Arbor Rentals leased office space to Lamar Corporation at the beginning of its fiscal year under a
seven-year operating lease agreement. The contract calls for annual rent payments of $100,000 each.
The office building was acquired by Arbor Rentals at a cost of $2 million and was expected to have a
useful life of 25 years with no residual value. Assume 2% lessor’s implicit rate.

What would be the impact of the lease on Lamar’s income statement for the first year?
Class Exercise
Arbor Rentals leased office space to Lamar Corporation at the beginning of its fiscal year under a
seven-year operating lease agreement. The contract calls for annual rent payments of $100,000 each.
The office building was acquired by Arbor Rentals at a cost of $2 million and was expected to have a
useful life of 25 years with no residual value. Assume 2% lessor’s implicit rate.

What would be the impact of the lease on Arbor Rentals’ income statement for the first year?
Lessor Accounting: Sales-Type Leases with Selling Profit
• Occurs when the fair value of the asset exceeds the cost or carrying value.
• Lessor recognizes a selling profit at the beginning of the lease term.
– Selling profit is the difference between sales revenue and cost of goods sold.
• When there is a selling profit, all lessor entries, other than the entry at the
beginning of the lease to include the selling profit, are precisely the same as the
entries for a sales-type lease without a selling profit.
• Lessor also recognizes interest revenue over the lease term.
Lessor Accounting: Sales-Type Lease with Selling Profit
On January 1, 2024, Time Publications leased printing equipment from Lenavo.
• The lease agreement specifies six annual payments of $100,000 beginning January 1,
2024, the beginning of the lease, and on each December 31 from 2024 through 2028.
• The six-year lease term ending December 31, 2029, is equal to the estimated useful life
of the equipment.
• Lenavo manufactured the equipment at a cost of $300,000.
• Using an interest rate of 10% for financing this transaction,
Lenavo calculates the present value of the lease payments to be received as
$479,079 ($100,000 × 4.79079*).
*Present value of an annuity due of $1: n = 6, i = 10%
Lessor Accounting: Sales-Type Lease with Selling Profit
Beginning of Lease (January 1, 2024)

Lenavo (Lessor)
Lease receivable (PV of lease payments) 479,079
Cost of goods sold (lessor’s cost) 300,000
Sales revenue (PV of lease payments) 479,079
Equipment (lessor’s cost) 300,000

Sales revenue $479,079

‒ COGS 300,000
Selling Profit $179,079
Lessor Accounting: Sales-Type Lease with Selling Profit
First Lease Payment (January 1, 2024)

Lenavo (Lessor)
Cash 100,000
Lease receivable 100,000
Remember, no interest has yet accrued when the
first payment is made at the beginning of the lease.
Class Exercise
Lamar Corporation entered into an arrangement, which qualifies as a capital lease, and calls for
annual lease payments of $26,269 over a six-year term (also the asset’s useful life) to Duval
Rentals. First payment is due at the beginning of the lease. The interest rate is 5%. Duval
manufactured the equipment at a cost of $125,000. What would be the impact of this transaction in
Lessor’s income statement in the first year
Real World Disclosure Note
Real World Disclosure Note
Class Exercise
Lamar Coffee Shop leased a specialty expresso machine for a 10-year noncancelable term. At the end
of the 10-year term, Lamar Coffee Shop has four consecutive one-year renewal options. A replacement
machine can be acquired, but due to expensive installation and Lamar’s lease term for its store, Lamar
expects to lease the machine for 12 years. What is the lease term?
Problem A
On January 1, 2022, Lamar Corporation enters into a lease agreement to lease a vehicle to Duval Technologies for three
years for lease payments of $2,900, payable annually at the end of each year. The Lessee & the Lessor each incurs initial
direct costs of $200 to enter into the lease. At the beginning of the lease, both the carrying amount (on Lessor’s books) and
fair value of the vehicle are $10,000 and the amount the lessor expects to derive from the vehicle at the end of Year 3 is
$3,000. The lessee has an option to purchase the vehicle at the end of the initial lease term at $3,500. The economic life of
the vehicle is four years, with zero residual expected at that time.

The lessee concludes that it does not have a significant economic incentive to exercise the purchase option and therefore
determines the lease term to be three years. Thus, the leased vehicle will be returned to lessor at the end of three years.

REQUIRED:
1. Compute the initial lease liability. What is the interest rate the lessor is charging the lessee?
2. What is the amortization period for the right-of-use asset?
3. Make the Lessee’s entries for the three years. Prepare the amortization table.
4. At the end of Year 3, what is the balance in lease liability and right-of-use asset, respectively?
Problem B
Assume the same facts as in Leases Problem A, except that the life of the asset is 5 years now, with zero
residual value anticipated at the end of the fifth year. Accordingly, lessee accounts for the lease of the vehicle as
an operating lease.

REQUIRED:
Record the lessee’s entries for all three years of the lease term.
Compare the lease expense for the Lessee under an operating lease to that under finance lease.
Problem C
Assume the same facts as in Leases Problem B, except that you are now focused on the lessor. Accordingly,
lessor accounts for the lease of the vehicle as an operating lease.

REQUIRED: Make the Lessor’s entries for all three years of the lease term.
Problem D
Tivoli Networks leased cloud-computing server racks to Lamar Corporation for five years. Tivoli manufactured
the server racks for $100,000. The racks have a sales amount of $130,000, an estimated life of five years, and
no residual value. The lease started on January 1, 2022. Tivoli used a target return of 7%. Payments are at the
beginning of the period.

REQUIRED:
1. Compute the lease payment
2. Give the entries at January 1, 2022, for Tivoli and Lamar