5 Ways to Determine If Leases are Operating or Financing
Once a company decides how it will track contracts to meet the Financial Accounting Standards Board’s (FASB) new lease accounting standard, it’s time to calculate the right-of-use asset and corresponding liability for your balance sheet. If there are a lot of different leases, it may be best to pick one of each lease type and calculate it first.
The incremental borrowing rate (IBR) first needs to be determined. This is an estimate of the interest rate a company would have to pay had they borrowed money to buy the asset. If there is a similar asset that is financed, that rate can be used. For instance, if there’s a mortgage on a similar building or a truck that’s financed, those rates are usable. As a side note, private companies can elect to use the risk-free rate, which would be the current government bond yields or interest yield curves such, as the LIBOR rate.
Once the IBR has been determined, the next step is figuring out whether the leases are operating or financing.
The term financing replaced the previous term “capital leases.” While accounting for financing leases is pretty much the same as it was under capital leases, the main difference is the term bargain purchase options is no more and the bright lines test is gone.
If any of the following conditions are met, it’s a financing lease:
- Transfer of ownership: The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- Bargain purchase option: The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- Lease term: The lease term is for the major part of the remaining economic life of the underlying asset, unless the commencement date of the lease falls at or near the end of the economic life of the underlying asset.
- Present value: The present value of the sum of lease payments and any residual value guaranteed by the lessee not already reflected in lease payments equals or exceeds substantially all of the fair value of the underlying asset.
- Specialized nature: The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
Consider this example from The CPA Journal in regard to financing leases:
Pike Industries Inc. leases a piece of equipment for five years on 1/1/Year 1. The equipment has a five-year economic life. The lease calls for annual payments of $25,000 of 12/31 of each year, and the implicit interest rate known to Pike is 5%. The lease conveys no ownership at the end of the lease term, contains no purchase option and requires no guarantee of residual value. Because the lease agreement is for the underlying asset’s entire five-year life, it is classified as a finance lease under the new standard. Pike depreciates similar assets on a straight-line basis.
For journal entries, using the example above, the first one will record the right-of-use asset and related liability at the present value of the lease payments. The second set of journal entries will record the interest expense with the amortization of the lease liability and the actual cash payment for the lease. There also may be a journal entry to record the depreciation expense and related accumulated depreciation. Remember, these journal entries are just like fixed asset capital leases.
In contrast, The CPA Journal offers the following example in regard to operating leases:
Pike Enterprises, Inc. leases a machine for three years on 1/1/Year 1. The machine has a fair value of $75,000, 1 10-year economic life and alternative expected used to the lessor after the lease term. The lease calls for annual lease payments of $10,000 on 12/31 of reach year, and the implicit interest rate known to Pike is 5%. The lease conveys no ownership at the end of the lease term, contains no purchase option and requires no guarantee of residual value. Because this lease doe not meet any of the five criteria for a finance lease, it is an operating lease under the new standard, but the lease term is greater than 12 months, so the new standard requires balance sheet presentation.
For journal entries, using the example above, the first entry will record the present value of the future lease payments. The next entry records the annual lease payment and expense, and the amortization of the operating lease liability offset against the operating right-of-use asset.
For leases that are 12 months or less, the lessee is permitted to elect to not put the short-term lease on the balance sheet and just straight-line the lease expense over the term.
Need help implementing your company’s process? Contact us today to see how we can help or view our recent webinar to help get you into compliance!
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