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Lease AccountingFASB 13 documents four kinds of leases; 1) Operating leases 2) Direct finance leases 3) Leveraged leases 4) Sales-type leases.Lessors use operating lease accounting treatment when they are likely to keep the asset when the lease is over. The lessor carries the asset on the balance sheet as an asset and records the monthly billings as revenues. Direct financing leases record the lease receivable on the balance sheet (instead of the equipment) itself. The transaction is judged to be a sale in substance, with the asset held as collateral for the financing. Leveraged leases use direct finance treatment with the additional recording of third-party debt. Sales-type leases use direct finance treatment with the additional recording of manufacturer's profits. Let's take a look at an operating lease accounting example: Equipment cost = 120,000 Lease term = 24 months Monthly payment = 3,000 Useful life = 60 months The entry to book this lease is the same as to purchase the asset: Equipment cost 120,000 Vendor payable 120,000 Each month we record book depreciation 120,000/60 months = 2,000 Depreciation expense 2,000 Accumulated depreciation 2,000 And rental income. Lease receivables 3,000 Lease income 3,000 Now let's look at a direct finance transaction: Equipment cost = 120,000 Lease term = 60 months Monthly payment = 3,000 Estimated residual = 12,000 The estimated residual value represents what the lessor thinks the equipment is going to be worth at the end of the lease transaction. If he sells the residual at the end for more than the book value he will record a profit for the difference between the cash received at the time of the sale and the original estimated book value he recorded at the time of lease inception. Gross receivables 180,000 Residual Receivable 12,000 Vendor payable 120,000 Unearned income 60,000 Unearned residual 12,000 Not all companies use an unearned residual account. Some companies compute the residual component and add it to the unearned income account. Initial Direct Costs(IDC) - lessors must amortize certain costs and cannot offset these costs against income at lease inception. The following entries represent a 10,000 initial direct cost: Capitalized IDC 10,000 Deferred IDC 10,000 The accounting entry for bad debt reserve is similiar. Bad debt reserves are often created after reviewing problem accounts and estimating future writeoffs related to those accounts. Let's use our previous example and assume a 2% bad debt percentage. Bad debt reserve = .02 * (180,000 + 12,000) = 3,840 Provision for bad debts 3,840 Reserve for bad debts 3,840 Unearned income 3,840 Lease income 3,840 Notice what these entries accomplish. The provision for bad debts and lease income are both income statement accounts. The net effect of the entries results in a zero bottom-line effect on the income statement. The balance sheet reflects an increase in the bad debt reserve and a reduction in unearned income. By reducing unearned income, we have reduced our basis for recognizing future lease income. The effect of this method, therefore, is to spread the bad debt expense over the lease term in the same fashion as lease income. Income Recognition Many leasing companies recognize earned income over time by ratably amortizing unearned income using an implicit rate (acturial rate). Leveraged Leases FASB 13 states that because this debt is an integral part of the lease transaction, it should be carried as an offset to the asset on the balance sheet instead of the normal classification of debt as a liability. Income from leveraged leases can be recognized on an after-tax basis. Residuals In our direct finance example, we booked a residual estimate on the balance sheet. With our operating lease example, we did not estimate a residual value in advance. Deferred Taxes Deferred taxes are the result of timing differences between book accounting and income tax accounting. A common example is the use of different methods of depreciation. Companies will often use an accelerated method for tax purposes (MACRS) to increase current tax deductions, but use a straight-line method for book purposes to show a better bottom line. Each year the company identifies areas such as depreciation that are different between book and tax. This often requires very detailed schedules. The current tax liability is calculated by applying the corporate tax rate to taxable income. The book tax provision must be calculated by applying the same corporate tax rate to book income. The difference between the book tax provision and the current tax liability is recorded as deferred taxes. |
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