Leases play a crucial role in business financing, impacting financial statements and ratios. This section dives into accounting for leases from both lessee and lessor perspectives, covering classification, recognition, and measurement.

Understanding lease accounting is vital for grasping off-balance sheet financing. We'll explore how different lease types affect financial reporting, including recent changes requiring most leases to be recognized on the balance sheet.

Finance vs Operating Leases

Lease Classification Criteria

• Finance leases transfer substantially all risks and rewards of ownership to lessee, operating leases do not
• Key criteria for finance lease classification
  • Transfer of ownership at end of lease term
  • Bargain purchase option for lessee
  • Lease term covers major part of asset's economic life (typically 75% or more)
  • Present value of lease payments approximates asset's fair value (typically 90% or more)
• Classification impacts financial ratios (debt-to-equity, return on assets)

Accounting Treatment Differences

• Lessee accounting
  • Finance leases capitalized on balance sheet as asset and liability
  • Operating leases typically expensed as incurred under some standards
• Lessor accounting
  • Finance leases treated as sale/financing transaction
  • Operating leases treated as rental agreements
• Recent standards (IFRS 16, ASC 842) require most leases on balance sheet for lessees

Financial Statement Impacts

• Finance leases increase assets and liabilities on balance sheet
• Operating leases have less balance sheet impact under some standards
• Income statement effects differ
  • Finance leases: Depreciation and interest expense
  • Operating leases: Single lease expense (typically straight-line)
• Cash flow statement classification varies (operating vs. financing activities)

Accounting for Leases

Lessee Accounting

• Finance leases
  • Recognize right-of-use asset and lease liability on balance sheet
  • Record depreciation expense on right-of-use asset
  • Recognize interest expense on lease liability
• Operating leases
  • Recognize lease payments as expense on straight-line basis over lease term
  • Some standards now require right-of-use asset and liability recognition
• Assess right-of-use assets for impairment (IAS 36, ASC 360)

Lessor Accounting

• Finance leases
  • Derecognize underlying asset
  • Recognize lease receivable and residual asset
  • Record interest income over lease term
• Operating leases
  • Continue recognizing underlying asset
  • Depreciate asset over its useful life
  • Recognize lease income (typically straight-line)

Lease Modifications and Reassessments

• Reassess lease term if significant event/change occurs
• Lease modifications may require recalculation of lease assets/liabilities
• Potential impacts on balance sheet and income statement
• Examples of modifications
  • Change in lease term
  • Change in lease payments
  • Change in assessment of purchase option

Lease Asset and Liability Measurement

Initial Measurement

• Lease liability
  • Present value of future lease payments
  • Discounted using rate implicit in lease or lessee's incremental borrowing rate
• Right-of-use asset initial measurement
  • Amount of lease liability
  • Plus: lease payments made at/before commencement
  • Plus: initial direct costs
  • Plus: estimated costs of dismantling/restoring asset
• Exclude variable lease payments not based on index/rate from initial measurement

Subsequent Measurement

• Lease liability
  • Increase carrying amount to reflect interest (effective interest method)
  • Reduce for lease payments made
  • Adjust for reassessments or lease modifications
• Right-of-use asset
  • Measure at cost less accumulated depreciation and impairment losses
  • Adjust for remeasurement of lease liability
• Variable lease payments
  • Recognize as expenses when triggering event occurs
  • Examples: payments based on sales or usage

Reassessments and Modifications

• Reassess lease term if significant event/change occurs
  • Example: decision to exercise renewal option previously considered unlikely
• Lease modifications may require recalculation
  • Example: change in lease payments due to index/rate change
• Adjust right-of-use asset and lease liability for changes
• Impact both balance sheet and income statement

Journal Entries for Leases

Initial Recognition Entries

• Finance lease - Lessee
  • Debit: Right-of-use asset
  • Credit: Lease liability
• Finance lease - Lessor
  • Debit: Lease receivable
  • Credit: Underlying asset
  • Credit: Unearned interest income

Periodic Entries

• Finance lease - Lessee
  • Debit: Depreciation expense
  • Credit: Accumulated depreciation
  • Debit: Interest expense
  • Credit: Lease liability
• Finance lease - Lessor
  • Debit: Cash/Receivable
  • Credit: Lease receivable
  • Debit: Unearned interest income
  • Credit: Interest income
• Operating lease - Lessee
  • Debit: Lease expense
  • Credit: Cash/Payable
• Operating lease - Lessor
  • Debit: Cash/Receivable
  • Credit: Lease income

Special Entries

• Lease modification
  • Adjust right-of-use asset and lease liability (lessee)
  • Recalculate lease receivable (lessor - finance lease)
• Impairment of right-of-use asset
  • Debit: Impairment loss
  • Credit: Right-of-use asset
• Variable lease payment
  • Debit: Lease expense
  • Credit: Cash/Payable