Components of leases include the lease term, estimated economic life of and estimated residual value of leased assets, minimum lease payments, implicit interest rate, and incremental borrowing rate. Direct financing, sales-type, and operating leases are generally used to lease property, plant, and equipment.
Direct Financing Leases
With direct financing leases, the lessor leases an asset to the lessee to earn interest revenue. In other words, the lessor acts as a financial intermediary by acquiring an asset at a favorable rate and later leases it to the lessee. Suppose Company A leases trailers from Spinner, Inc. Because this is a direct financing lease, Spinner will first purchase the trailers from a manufacturer or dealer then lease the trailers to Company A at an amount that will recover its initial investment in the trailers plus generate interest revenue during the lease term. Lessors issuing direct financing leases often lease assets at consistent rates for specific assets. For example, if Spinner generally leases auto-related assets to other firms at an interest rate of 8%, it will likely lease the trailers to Company A at 8% for a specified term. Therefore, it would be ideal to research the average rate used by a company for specific assets prior to selecting the direct financing lease option.
Sales-type leases are similar to direct financing leases because the lessor generates interest revenue by the leasing assets. Unlike direct financing leases, the lessor receives a manufacturer’s or dealer’s profit on the sale of the asset. A lease qualifies as a sales-type lease only if the lessor generates a profit on the sale of the asset. For example, if a lessor purchases five trailers for $300,000 and later leases the trailers to a lessee with the total minimum lease payments equaling $450,000; the lessor will receive a profit of $150,000 over the term of the lease. The lease is classified as a direct financing lease if the lessor does not generate profit from the lease payments. Because lessees record direct financing and sales-type leases in the same manner, the classification of either lease does not affect the financial statements of the lessee. Lessees record the lease at the present value of the lease payments and the first rental payment at the inception of the lease.
Inception of lease (Lessee):
(1) Leased equipment XXXX
Lease payable XXXX
(2) Lease payable XXXX
Cash (lease payment) XXXX
All subsequent lease payments are recorded in the same manner as the lease payment (2), but the payments are allocated between the amount paid towards the lease and the interest expense.
Subsequent lease payments (Lessee):
Interest expense (Interest rate x (PV of payments – rental payment) XXXX
Lease payable (Rental payment – interest XXXX
Cash (lease payment) XXXX
Operating leases are similar to rental agreements because the lessor retains ownership of an asset while renting it to a lessee. Accounting for operating leases is relatively straightforward; the lessor records rent revenue and the lessee records a rent expenses. Although accounting for operating leases is simple, complications can arrive. For example, the lessee may make improvements to the leased asset. These improvements are referred to as leasehold improvements. When leasehold improvements are made the lessee allocates the cost as a depreciation expense over the useful life of the asset. Additional complications arise when the residual value of an asset is guaranteed by the lessee. The estimated commercial value of an asset at the end of the lease term is its residual value. The minimum payments are calculated to include an additional lease payment at the end of the lease term if the lessee guarantees the residual value of an asset. For example, if the periodic rental payments of a lease are $93,000 per year for 6 years and the anticipated residual value of the leased asset is $60,000, the lessee will pay the lessor $93,000 per year for the first six years, and then make the $60,000 guaranteed residual value payment in the seventh year.
"Intermediate Accounting", David Spiceland, 2009