Not all leases are alike. Leases are generally constructed in a manner beneficial to the lessee, lessor, or both. As a result, most leases have specific features that make them unique and in some cases create accounting problems. Special features of leases that create accounting issues include, but are not limited to, leasehold improvements and executory costs. Leasehold improvements occur when the lessee makes improvements to leased property that reverts back to the lessor when the lease ends; Executory costs are maintenance, insurance, taxes, and all other expenses associated with ownership that a lessee is required to pay per the lease agreement. The major problem with leasehold improvements is that some companies allocate the cost incorrectly. Leasehold improvements should be expensed over the lease term; however, most companies erroneously allocate the cost over leased assets’ estimated useful life. Allocation of executory costs is generally simple because they are expensed by the lessee as they are incurred. However, if the lease agreement states that the rental payments are a higher amount because they include executory costs, the lessee must list these cost separate from minimum lease payments.
Residual value is the estimated commercial value of a leased asset at the end of the lease period. The effect of residual value is dependent on if the lessee guarantees the lessor will recover the value when the asset is reverted at the end of the lease period. When the residual value is guaranteed, the lessee promises to provide the lessor with an additional lease payment that is included in the minimum lease payments. When the residual value is not guaranteed, the lessee is only obligated to make periodic lease payments.