ACC 306 Intermediate Accounting II
Instructor Robert Neely
January 14, 2013
Leases are used by companies and individuals to facilitate asset acquisition. They are accounted for in different ways, depending on whether they are operating leases or capital leases, and the type of financial report being generated. Residual value is important in accounting for leases and lease payment. Executory costs are accounted for as well, and are a consideration in the cost of the lease payments. Leasing arrangements can be complex and take a great deal of consideration by both the lessor and lessee before agreements are made. This paper defines a lease and how it is used as a financial vehicle, how leases are accounted for, the difference between capital and operating leases, and other factors, such as residual value and executory costs. A lease is a contractual arrangement between one party that provides the right to use an asset, for a specified amount of time and for a specified fee, to another party. The party providing the use of the asset is called the lessor, while the party leasing the asset is called the lessee. In lease arrangements, lessees agree to make stipulated, periodic cash payments during a time period specified within the lease agreement for the use of the lessor’s asset (Spiceland, Sepe, & Nelson, 2011, p. 808). There are many types of leases that people are familiar with, such as leases for buildings or apartments, equipment leases, and vehicle leases. As there are different types of leases, they all fall under different classifications of either operating leases or capital leases. Operating leases are short term agreement when fundamental rights and responsibilities of ownership are retained by the lessor and the lessee is simply using the asset temporarily. An apartment lease is a prime example of what is classified as an operating lease. Capital leases are arrangements that are formulated outwardly as leases, but are actually installment purchases/sales. Basically, these leases transfer all risks and rewards to the lessee, as well as ownership of the asset at the end of the lease term, as in a sale transaction (Zarowin, n.d.). A lease must hold at least one out of the four criteria to classify it as a capital lease. If it does not meet any of the four criteria by both the lessor and the lessee, then it is considered an operating lease. The four criteria are: 1. The lease transfers ownership of the property to the lessee by the end of the lease term. 2. The lease contains a bargain purchase option to purchase the leased property at a bargain price. 3. The lease term is equal to 75% or more of the expected economic life of the asset. 4. The present value of the minimum lease payments at the inception of the lease, excluding executory costs, is equal to or greater than 90% of the fair value of the asset. For the first criterion, if the ownership of the property were given to the lessee during or after the term of the lease, then it is evident of a capital lease. The second criterion of the lease containing a bargain purchase option means that a provision has been made in the lease contract allowing the lessee the option of purchasing the property at a bargain price (Doye, Hobbs, & True, 2011). The third criterion basically means that the lessor is leasing the property to the lessee for most of its useful life; therefore most of the benefits and responsibility of ownership are transferred to the lessee. The use of this criterion can be difficult because the lease term can be uncertain and it may prove challenging to estimate the economic life of the property. The fourth criterion means that if the lease payments substantially pay for the leased property (90% or more), it is reasonable to classify the lease agreement as equivalent to an installment purchase. Lessors have more conditions to follow in order to...