Accounting for leases in the United States

Article Source: http://en.wikipedia.org/wiki/Accounting_for_leases_in_the_United_States

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.
How to calculate the lease rate:
[Monthly Lease Payment] x [Term (months)] = [Total amount out of pocket]
[Total amount out of pocket] - [Financed amount] = [Total finance charge]
[Total finance charge] / [Term (years)] = [Finance charge per year]
[Finance charges per year] / [Financed amount] = Annual Lease Rate
The accounting profession recognizes leases as either an operating lease or a capital lease (finance lease). An operating lease records no asset or liability on the financial statements, the amount paid is expensed as incurred. On the other hand, a capital lease is recorded as both an asset and a liability on the financial statements, generally at the present value of the rental payments (but never greater than the asset's fair market value). To distinguish the two, the Financial Accounting Standards Board (FASB) provided criteria for when a lease should be capitalized, and if any one of the criteria for capitalization is met, the lease is treated as a capital lease and recorded on the financial statements. The primary standard for lease accounting is Statement of Financial Accounting Standards No. 13 (FAS 13), which has been amended several times. In July 2006, the FASB and the International Accounting Standards Board (IASB) announced the commencement of a joint project to comprehensively reconsider lease accounting. In July 2008, the boards decided to defer any changes to lessor accounting, while continuing with the project for lessee accounting, with the stated intention to recognize an asset and obligation for all lessee leases (in essence, eliminating operating lease accounting). The projected completion of the project is now 2011. ^[1][2] The basic criteria for capitalization of a lease by lessee are as follows:

• The lessor transfers ownership of the asset to the lessee at the end of the lease term.
• 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.
• The life of the lease is equal to or 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.

These are called the 7(a)-7(d) tests, named for the paragraphs of FAS 13 in which they are found.
If any of the above are met, the lease would be considered a capital or financing lease and must be disclosed on the lessee's balance sheet. Conversely, if none of the criteria are met, the contract is an operating lease, and the lessee will have a footnote in its balance sheet to that effect. Both parties (lessor and lessee) must review these criteria at the outset and determine independently the classification as it is possible to classify them differently (it is quite common, in fact, for a single lease to be considered a capital lease by lessors and an operating lease by lessees).
If the term of the lease does not exceed 12 months, the lease may be considered neither of the above criteria. These contracts are "rentals" and do not need to be disclosed in lessee's footnotes.
For a more in depth explanation, see the accounting textbook Intermediate Accounting, 11th ed, Kieso Weygandt Warfield.

[edit] Lessee Accounting

Under an operating lease, the lessee records rent expense (debit) over the lease term, and a credit to either cash or rent payable. If an operating lease has scheduled changes in rent, normally the rent must be expensed on a straight-line basis over its life, with a deferred liability or asset reported on the balance sheet for the difference between expense and cash outlay.^[3]
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.
For both capital and operating leases, a separate footnote to the financial statements discloses the future minimum rental commitments, by year for the next five years, then all remaining years as a group.
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. If the life of the leasehold improvement extends past the life of the initial term of the lease and into an option period, normally that option period must be considered part of the life of the lease.^[4]

• 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. This is not reported as part of the future minimum rental commitments disclosure, nor in the 7(d) test to determine whether the lease is capital or operating.

[edit] 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.

[edit] Notes

1. ^ FASB Project Update: Leases
2. ^ IASB Current Projects: Leases
3. ^ FASB Technical Bulletin 85-3
4. ^ Letter from SEC Chief Accountant, Feb. 7, 2005