9.3 Lessor Accounting and Reporting
4 min read•july 30, 2024
Lessor accounting involves classifying leases as sales-type, direct financing, or operating. Each type has distinct recognition, measurement, and income calculation methods. Understanding these differences is crucial for accurately reporting lease transactions in financial statements.
Lessors must evaluate criteria, record appropriate journal entries, and present lease-related information in financial statements. This includes recognizing net investments in leases, calculating , and disclosing key details about leasing arrangements and associated risks.
Lease Classifications for Lessors
Sales-Type Leases
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- Transfer control of the underlying asset to the
- Lessor expects to derive a profit from the lease in addition to interest income
- Fair value of the leased asset is different from its carrying amount
- Example: Lessor leases a piece of equipment with a fair value of 80,000 for a term that covers a major part of the asset's economic life
Direct Financing Leases
- Transfer control of the underlying asset to the lessee
- Lessor does not expect to derive a profit from the lease other than interest income
- Fair value of the leased asset is the same as its carrying amount
- Example: Lessor leases a vehicle with a fair value and carrying amount of $30,000 for a term that covers a significant portion of the vehicle's economic life
Operating Leases
- Do not transfer control of the underlying asset to the lessee
- Lessor retains substantial risks and rewards associated with the ownership of the leased asset
- Example: Lessor leases office space for a term of 3 years, which is significantly shorter than the building's economic life of 30 years
Lease Classification Criteria
- Evaluate the transfer of ownership
- Assess the existence of a purchase option
- Compare the lease term to the economic life of the asset
- Calculate the in relation to the fair value of the asset
- Determine the specialized nature of the asset
Lease Recognition and Measurement
Sales-Type Leases
- Lessor derecognizes the leased asset
- Recognizes the net investment in the lease (lease receivable and unguaranteed residual asset)
- Records any selling profit or loss
- Lease receivable measured at the present value of the lease payments not yet received, discounted using the rate implicit in the lease
- Unguaranteed residual asset measured at the present value of the amount the lessor expects to derive from the underlying asset following the end of the lease term
Direct Financing Leases
- Lessor derecognizes the leased asset
- Recognizes the net investment in the lease (lease receivable and unguaranteed residual asset)
- No selling profit or loss is recorded
Operating Leases
- Lessor retains the leased asset on its
- Does not record a lease receivable or unguaranteed residual asset
Lease Income Calculation
Sales-Type Leases
- Lessor recognizes interest income on the net investment in the lease using the effective interest method
- Recognizes any variable lease payments and impairment losses
- Effective interest method allocates interest income over the lease term on a systematic and rational basis, producing a constant periodic rate of return on the net investment in the lease
Direct Financing Leases
- Lessor recognizes interest income on the net investment in the lease using the effective interest method
- Recognizes any variable lease payments and impairment losses
Variable Lease Payments
- Payments that depend on an index or rate are included in the measurement of the net investment in the lease using the index or rate at the commencement date
- Changes in variable lease payments are recognized in profit or loss in the period of the change
Journal Entries for Leases
Sales-Type Leases
- Initial journal entry:
- Debit lease receivable and unguaranteed residual asset
- Credit leased asset
- Credit any selling profit (or debit selling loss)
- Subsequent journal entries:
- Debit cash and credit lease receivable for lease payments received
- Debit interest income and credit lease receivable for interest earned
Direct Financing Leases
- Initial journal entry:
- Debit lease receivable and unguaranteed residual asset
- Credit leased asset
- Subsequent journal entries:
- Debit cash and credit lease receivable for lease payments received
- Debit interest income and credit lease receivable for interest earned
Operating Leases
- No initial journal entry required (leased asset remains on lessor's books)
- Subsequent journal entries:
- Debit cash and credit lease income for lease payments received
Impairment Losses
- Debit impairment loss and credit lease receivable for any impairment losses on the net investment in the lease
Lease Presentation in Financial Statements
Balance Sheet
- Sales-type and direct financing leases: Present net investment in the lease (lease receivable and unguaranteed residual asset)
- Operating leases: Leased asset remains on the balance sheet
Income Statement
- Sales-type and direct financing leases: Present selling profit or loss (if any), interest income, variable lease income, and impairment losses
- Operating leases: Present lease income
Statement of Cash Flows
- Operating leases: Present lease payments received as operating activities
- Sales-type and direct financing leases:
- Present principal portion of lease payments as investing activities
- Present interest portion as operating activities
Disclosure Requirements
- Describe the nature of leasing arrangements
- Disclose significant judgments made in applying the leasing standard
- Present the components of the net investment in the lease
- Provide a maturity analysis of lease receivables
- Disclose information about how the lessor manages its risk associated with the residual value of leased assets
Key Terms to Review (14)
Balance Sheet: A balance sheet is a financial statement that provides a snapshot of a company's assets, liabilities, and equity at a specific point in time. It shows what the company owns and owes, offering insight into its financial health and stability.
Control over the asset: Control over the asset refers to the power to govern the use of an asset, enabling the holder to direct its economic benefits and manage its risks. This concept is crucial for lessor accounting and reporting, as it determines how an asset is recognized and measured on financial statements. Understanding control helps distinguish between operating leases and finance leases, influencing how both lessors and lessees approach asset management and financial reporting.
Depreciation expense: Depreciation expense is the systematic allocation of the cost of a tangible asset over its useful life, reflecting the reduction in value as the asset is used. This accounting concept helps businesses match the expense of using an asset with the revenue it generates, providing a clearer picture of profitability. It’s crucial for both lessees and lessors in financial reporting, as it affects net income and asset values on financial statements.
Disclosure Requirements: Disclosure requirements are the set of rules and regulations that dictate what information companies must provide to stakeholders in their financial statements and reports. These requirements ensure transparency and consistency, allowing users to make informed decisions based on the financial health and performance of the entity. They are crucial for various accounting practices, guiding how lessors recognize lease income, how companies handle changes in accounting principles, how business combinations are reported, and how foreign currency transactions and hedging activities are disclosed.
Income Statement: An income statement is a financial report that summarizes a company's revenues, expenses, and profits or losses over a specific period, typically a quarter or a year. It provides key insights into the company's operational performance, allowing stakeholders to assess profitability and efficiency in generating income.
Lease classification: Lease classification is the process of determining whether a lease is classified as a finance lease or an operating lease based on specific criteria. This classification affects how both lessors and lessees recognize and report lease transactions in their financial statements. Accurate lease classification is essential for financial reporting, as it influences the balance sheet, income statement, and cash flow statement.
Lease income: Lease income is the revenue generated by a lessor from leasing out property or assets to a lessee. This income typically consists of rental payments made by the lessee, which can vary based on the lease agreement terms, including fixed payments, variable payments linked to an index, or contingent rentals. Understanding lease income is essential for accurately reporting financial performance and evaluating the profitability of leasing activities.
Lease liability: A lease liability is the present value of future lease payments that a lessee is obligated to make over the term of a lease. This obligation reflects the right to use an asset and requires the lessee to recognize the liability on their balance sheet, impacting financial reporting and ratios. It plays a crucial role in both the accounting for lessees who take on leases and lessors who manage those leases.
Lessee: A lessee is an individual or entity that leases an asset from another party, known as the lessor, for a specified period in exchange for periodic payments. This arrangement allows the lessee to use the asset without owning it outright, which can be advantageous for managing cash flow and accessing expensive resources. Lessees must adhere to the terms of the lease agreement, which outlines their rights and responsibilities regarding the use of the leased asset.
Minimum Lease Payments: Minimum lease payments refer to the total amount of payments a lessee is obligated to make over the lease term, excluding costs for contingent rent, taxes, and other variable payments. This concept is crucial for lessors when recognizing revenue and determining the present value of future cash flows related to leased assets. Understanding minimum lease payments helps in accurately reflecting lease transactions in financial statements and maintaining compliance with accounting standards.
Present value of lease payments: The present value of lease payments refers to the current worth of future lease payment obligations, discounted at a specific interest rate. This concept is critical in financial accounting as it helps both lessees and lessors determine the value of leasing transactions, impacting how leases are reported in financial statements and evaluated in terms of cash flow.
Qualitative Disclosures: Qualitative disclosures refer to the non-numerical information that provides context and insights regarding a company's financial position and performance. These disclosures enhance the understanding of financial statements by explaining management's judgments, estimates, and the nature of risks involved in operations, which are crucial for lessor accounting and reporting.
Sales-type lease: A sales-type lease is a lease in which the lessor recognizes a profit on the sale of the leased asset at the commencement of the lease term. This type of lease occurs when the fair value of the leased asset at the beginning of the lease exceeds its carrying amount, and it results in both revenue recognition and asset disposal for the lessor.
Substantially all risks and rewards: Substantially all risks and rewards refers to the transfer of the significant benefits and obligations associated with an asset, typically in the context of leasing agreements. When a lessor retains substantially all risks and rewards related to an asset, they continue to have the primary responsibility for potential losses and the opportunity for gains. This concept plays a critical role in determining how leases are classified and reported, influencing financial statements and the lessor's accounting methods.