Lessee Accounting
Lessee accounting is crucial for businesses leasing assets, especially with new standards like IFRS 16 and ASC 842, which shift from off-balance-sheet to on-balance-sheet models for greater transparency. This ensures accurate financial reporting and better strategic decisions. This page outlines the key principles of lessee accounting to help financial professionals navigate these changes.
| Representative Task | Skill |
|---|---|
| Recall the accounting treatment for residual value guarantees, purchase options and variable lease payments. | Remembering and Understanding |
| Identify lease classification criteria (operating vs. finance leases). | Application |
| Calculate the carrying amounts of lease assets/iabilities and journalize transactions. | Application |
| Calculate lease costs recognized in the income statement. | Application |
Introduction to Lessee Accounting
What is Lessee Accounting?
Lessee accounting refers to the way businesses record and report leases on their financial statements. Under ASC 842 (US GAAP) and IFRS 16, most leases must be recorded on the balance sheet, increasing transparency in financial reporting.
Key Lease Accounting Terms
| Term | Definition |
|---|---|
| Right-of-Use (ROU) Asset | Represents the lessee's right to use a leased asset. |
| Lease Liability | Obligation to make lease payments, measured at the present value of future lease payments. |
| Lessor | Person or company renting out the space or asset. |
| Lessee | Person who wants to use the asset in their business. |
Lease Classifications
Under ASC 842, a lease is a finance lease if any of the following 5 criteria are met:
- Transfer of Ownership: Ownership transfers to the lessee by lease end.
- Purchase Option: If the lessee is reasonably certain to exercise a purchase option.
- Lease Term: If the lease term is ≥75% of the asset's economic life.
- Present Value: PV of lease payments ≥90% of the asset's fair value.
- Specialized Asset: Asset has no alternative use to the lessor at lease end.
If none apply, the lease is classified as an operating lease.
Key Differences:
| Feature | Finance Lease | Operating Lease |
|---|---|---|
| Asset Ownership | Transfers to lessee | Remains with lessor |
| Expense Type | Depreciation + Interest | Straight-line Lease Expense |
| Balance Sheet Impact | ROU Asset + Lease Liability | ROU Asset + Lease Liability |
RVGs, Purchase Options & Variable Lease Payments
Residual Value Guarantee (RVG)
A commitment from the lessee that the value of the asset at lease end meets a specified amount.
- Accounting Treatment:
- Include the probable amount payable under the RVG in the lease liability.
- If expectations change, remeasure the lease liability using the original discount rate.
Purchase Options
A right to purchase the asset at a specified price at the end of the lease.
- Bargain Purchase Option:
- If the lessee is reasonably certain to exercise the option, include the purchase price in the lease liability.
- This typically results in the lease being classified as a finance lease.If nodnux leases an asset for 10 years, and at the end of the lease I have the option to buy the asset for $10,000 when the market value is $12,000, that makes it a bargain purchase option for me.
Variable Lease Payments
A payment that is not fixed- and is based on an index or asset usage.
- Types:
- Index/Rate-Based: Initially measured using the index/rate at lease commencement.
- Usage-Based: Recognized in profit or loss in the period incurred; not included in lease liability.
Carrying Values of Lease Assets and Liabilities
Practice Task 1
Canlin Consulting enters into a lease agreement on January 1, 2025, to lease specialized IT equipment. The lease term is 4 years, with annual lease payments of $25,000 due at year-end. The discount rate is 7%, and the fair value of the equipment is $85,000. Ownership transfers at the end of the lease. The present value of an ordinary annuity for 4 years at 7% is 3.3873. Since ownership transfers at the end, the lease qualifies as a Finance Lease under ASC 842.
Required: Record the initial Right of Use Asset, complete the lease schedule for the life of the loan and any necessary journal entries for the first year.
ROU Asset and Lease Liability
To prepare the initial journal entry, we need to calculate the Present Value (PV) of the Lease Payments by multiplying the actual annual lease payment by the present value of an annuity for 4 years at 7% from the annuity table (3.3873 - given).
Lease Schedule
To calculate a correct lease schedule, we need the initial Lease Liability from above. The lease schedule is used to calculate the interest expense and principal reduction for each period of payment during the lease term.
Year-End Entries
Every year (or period if payments are more than once a year) we need to record the payment (or an accrual) and the depreciation expense of the ROU Asset.
There are two entries to recording these transactions:
- The interest expense and Lease Liability reduction.
- Straight-line depreciation of the ROU Asset over the lease term.
Lease Costs in the Income Statement
Finance Lease
A finance lease has two components that affect the income statement- interest expense using the effective interest method and amortization expense of the ROU asset.
- Interest Expense: Effective interest method on lease liability.
- Amortization Expense: Straight-line over the asset's useful life or lease term, whichever is shorter.
Operating Lease
An operating lease has only one component that affects the income statement- a lease expense.
- Lease Expense: Straight-line over the lease term, combining interest and amortization.